Crisis Talk - The World Bank Group

More on bubbles

A few days ago I offered a series of bubble warnings from a German financial pundit, two academics, the man who broke the Bank of England, and the man who built Singapore. Today, we have a warning from the world's largest bond fund.

Free Exchange links to a discussion (via Buttonwood) about asset inflation, led by Pimco's Bill Gross.

Bottom line:

Cumulatively, asset values have risen twice as fast as GDP over the 50 year period. As Gross writes "you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce."

Nuff said.

Today in Bubbles

The editors of the Financial Times appear to be concerned about bubbles. Three out of today's four op-eds are dedicated to the theme.

First, George Soros argues that the implosion of 2008 was an aggregation of a series of bubbles over the past decades, creating, in his words, a "super-bubble":

The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further.

The Case for Prudency: Latin America Edition

Bloggers at the IMF are looking at why Latin America fared better in this crisis than during previous episodes of financial duress. Their explanation: financial soundness mixed with enhanced credibility.

This improvement can be attributed to the fact that the region faced the crisis equipped with economic policy frameworks that were more solid and credible than in the past, and with smaller financial, external, and fiscal vulnerabilities. This allowed a number of countries of the region to implement countercyclical monetary and fiscal policies.

The estimates here suggest that these countries were able to “save” about 4 percentage points of GDP during the crisis, thanks to their better preparations for confronting external shocks.

A key element of this preparedness was credibility. Those countries which had responsibly managed their monetary and fiscal policies before the crisis were able to quickly lower interest rates, while increasing public expenditure and fiscal deficits. Countries such as Brazil, Chile and Peru managed to store away enough revenues from the commodity booms of the previous years in order to enact the necessary mix of countercyclical policies. Mexico, which is suffering from dwindling oil reserves, had less of a cushion, and has in turn struggled more than most of its neighbors.

Update: Vox has an interesting paper on the policy responses of Latin America Central Banks during the crisis, written by the former governor of the Central Bank of Ecuador.

Rising Reserves

One sign of crisis abatement is the downward slide of the US dollar. As the market rediscovers its appetite for risk, the dollar's appeal as a safe haven currency diminishes. Indeed, the dollar has become the de facto carry trade currency. 

The market has renewed its faith in emerging markets, and the US has more tools to repair its trade balance and begin a phase of export-led growth? Is this a win-win situation? Not quite.

Although the dollar may be weakening, this weakening hasn't stopped central banks from accumulating more dollar reserves. In fact, dollar weakness may be accelerating accumulation.

Last week, several emerging market countries intervened in currency markets in order to prop up the dollar (or, rather, to push down their own currencies).  This involves buying dollars: Russia recently picked up $1.4bn in a single day, and $4bn in the same week.  

What are central banks doing with these dollars? Most of them are tucking them away for a rainy day, having seen the benefits of such accumulation during the crisis.

World Economic Forum Financial Development Report

The World Economic Forum has released its Financial Development Report 2009, which scores and ranks 55 of the world’s leading financial systems and capital markets according to their level of financial development. It analyzes the drivers of financial system development and economic growth in developed and developing countries to serve as a tool for countries to benchmark themselves and establish priorities for reform.

The United Kingdom replaced the US as this year's top performer. America's fall is largely due to lower financial stability scores and a weakened banking sector:

 

The report also highlights the impact of the financial crisis on the Millennium Development Goals. Erik Feyen, Financial Economist in the World Bank’s Financial and Private Sector Development Vice Presidency, has written a chapter in the report that highlights this impact.

Below is an excerpt:

Exchange Rate Movements in the Crisis and Beyond

Editor's note: Sebastian Weber and Charles Wyplosz are from the Graduate Institute in Geneva. They are the authors of a World Bank working paper on Exchange Rates during the Crisis.

A key leitmotiv as the financial crisis unfolded was to avoid a repeat of the policy mistakes of the Great Depression, including the beggar-thy-neighbour competitive devaluations which have had devastating effects causing rising protectionism and a collapse of international trade (Kindleberger, 1973).

Unlike in the 30s, only some 42% of countries are officially pegging their exchange rate today, implying that movements in the exchange rate do not necessarily reflect official decisions, but are rather market-driven. Furthermore, governments today have many more policy tools at hand, ranging from fiscal policy over labour markets to monetary policy measures, making them less reliant on measures that are perceived as beggar-thy-neighbour.

While exchange rates have moved a lot since the onset of the crisis, these movements have mostly been interpreted as a byproduct of expansionary policies and the move to ‘quality’. Sharp depreciations in countries like the UK or South Korea have not been welcomed by the authorities, at least not officially. Intentions, of course, are hard to detect and no one will argue that expansionary policies were not needed.

 

Local Bond Markets: From Strength to Strength

Most emerging markets are having a better crisis than their G7 counterparts. One sign of robustness in emerging markets is the growing importance of their local bond markets. A new paper from Vox by Ismali Dalla and Heiko Hesse (of the IMF) takes a look at how local-currency bond markets are becoming a viable funding alternative for many emerging market issuers.

Not surprisingly, many of the countries that have succeeded in weathering the worst of the crisis (China, India, Brazil, Poland) also have substantial local bond markets:

 

Global Monetary Architecture Matters

Editor's Note: Nadia Piffaretti is an assistant to the Chief Economist at the World Bank Group and a Special Assistant to the Senior Vice President. She is the author of an upcoming paper on Reshaping the International Monetary Architecture.

The crisis has taught us that economists ought to believe their own warnings about systemic vulnerability. If analysis points out that a system can fail, it probably will at some point. Knowing what we know today, having experienced – in a sort of “real-life economic laboratory” – how systemic vulnerabilities can transmit and amplify shocks, we cannot avoid turning a worried eye to the largely imbalanced growth of the global economy.

Before this crisis, many economists had warned about another crisis – a disorderly unwinding of global imbalances. It didn’t happen. It still may.

While most recently global imbalances have been narrowing, due to short term factors (like oil prices), the IMF is forecasting a widening again starting in 2010. At the same time, conditions do not seem to be reunited for a clear shift of growth engines at both sides of the global imbalances, especially at a juncture when governments attempt to calibrate exit-strategies from fiscal stimuli, walking the fine line between possible fiscal unsustainability, and the risk of too early withdrawal of stimulus.

It is against this backdrop, and the realization that the international monetary architecture looks vulnerable indeed, that I reminded myself of the almost forgotten “1941 Keynes’ Plan” which the “Master” had elaborated in view of the Bretton Woods negotiations.

The plan stemmed from the idea that monetary architecture matters.

Emerging Market Merry-go-Rounds

Paul Kedrosky writes about one of my favorite topics, emerging market decoupling. He cites a new report by HSBC which discusses a "global monetary merry-go-round":

Our optimistic views on the emerging world are also based on what we call the monetary merry-go-round. Low US interest rates typically encourage capital to flow into the emerging world. Attempts by emerging nations to limit the resulting exchange rate appreciation lead to offsetting capital outflows in the form of rising foreign exchange reserves which are often invested in US Treasuries. Higher demand for Treasuries keeps yields low and, hence, leaves US interest rates low, thereby allowing the merry-go-round to repeat, seemingly ad infinitum.

History Lessons

As the crisis enters its second year, the economic history books have already begun publishing an early account of first stages of the crisis. In particular, two articles have been released this week that serve as essential reading.

First, this month's Vanity Fair features an excerpt from Andrew Ross Sorkin's upcoming book, Too Big to Fail. Sorkin's piece gives a thrilling, minute by minute account of the chaos within the halls of Wall Street during the aftermath of the Lehman collapse. The article offers a view of the day's events through the perspective of the most important players in finance, including Timothy Geithner.

The IMF's Medium-term Outook: Anything is Possible

The IMF released the latest chapters of its World Economic Outlook, which focuses on building a sustainable recovery. The first chapter addresses lessons for monetary policy from asset price fluctuations, while the second deals with the impact of the crisis on medium-term output.

The IMF believes that the crisis has not yet struck a dagger into the heart of medium-term growth prospects, but it does pose serious risks. Historically, the seven-year impact of banking crises reduces output levels by 10 percent of their pre-crisis trend. Things tend to improve afterwards, and a permanent decrease in medium-term output growth is rare.

Yet this has been an a-typical banking crisis, and as such, governments face a complex juggling act in shielding the global economy from acquiring a few scars:

Emerging Market IPOs: Leading the way

Two years ago, as financial markets in the United States and Europe began to break down, there was much speculation over whether emerging markets would continue to grow in spite of the woes in the West. A year ago, this idea of decoupling was quickly dispelled.

As emerging markets rebound from the crisis, will there be a new decoupling, where they grow, and OECD economies struggle? It is probably too early to tell, but in one area, IPOs, developed economies are profiting from emerging market successes.

The Fed's Next Move: Hibernation

Yesterday I commented on the role of inflation in the crisis, which was explored at length during a symposium on Dealing with America's Debt Overhang. Any good conversation about inflation has to be followed with a discussion about the Federal Reserve.

Liaquat Ahamed, author of Lords of Finance: the Bankers Who Broke the World, gave a summary of the Fed's exceptional role during the crisis, which can be broken down into three key areas:

1. Acting as a lender of last resort
2. Aggressively cutting interest rates
3. Lending against assets that would normally be considered unacceptable collateral

The Bernanke Fed has been lauded for having prevented another Great Depression, and many, including Barack Obama, consider Bernanke to have been the right man for the right job at the right time.

But times are changing, and now that we are no longer looking into the abyss, what's next for the Fed? What role should it play in the recovery?

The Case for Inflation; or, The End of Orthodoxy

I attended a symposium this morning on America's Debt Overhang, hosted by the non-partisan New America Foundation (NAF). There were several interesting discussions about the present and future implications of America's ballooning public, private and household debts. I will return to these debates in greater detail tomorrow.

One presentation in particular stood out: Christopher Hayes, a fellow at NAF, presented a controversial paper entitled Overcoming America's Debt Overhang: The Case for Inflation.

Hayes argues that America's debt burden has become crippling. Indeed, household debt has risen from 48 percent of GDP in 1981 to 97 percent today. Meanwhile, corporate debt has grown from 22 percent in 1981 to 120 percent in 2009. The federal government is borrowing and spending at unprecedented peacetime rates. This toxic cocktail may spiral out of control:

One Year On

On the one-year anniversary of the Lehman Crisis, the biggest names in financial punditry have been voicing their thoughts and concerns on the most important issues facing the world economy.  Let's take a look:

Martin Wolf, who spent most of the crisis bringing attention to global imbalances, has become a China bull:

China has emerged as the most significant winner from the global financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?

Crisis Roundup: Anniversary Edition

Is another boom around the corner?

Or has the real pain only begun?

Fedex can't find any green shoots in the US...

...and American consumers can't find any more credit.

Is the end near for the dollar? Probably not.

Hank Paulson doesn't use email. Can he be trusted?

The upside to rising foreclosures.

Systemic Risk and the Financial Sector

I'm being called Mr. Bailout. I can't do it again.

-Hank Paulson, September 2008.

The IMF held an unofficial conference yesterday on systemic risks in financial systems. Kay Giesecke from Stanford University presented a paper which argues that the the spillover effects from the failure of a financial firm play a prominent role in systemic risk, far greater than the failure or default of an industrial giant:

We find strong evidence for the presence of spillover effects in the US financial system during 1987-2008, after controlling for the exposure of firms to common or correlated risk factors.  The fraction of systemic risk explained by spillover effects can be substantial, and tends to be higher during periods of economic stress.

Bank failure clusters do not arise solely from exogenous shocks; rather, they are pushed over the edge by the failure of their peers. 

While it may seem obvious that bank failures pose a greater systemic risk threat then other sectors, it wasn't obvious enough to Mr Paulson.

Or, he just let it happen anyway.   

Wall Street's Premature Exuberance

I've been wondering lately if investment banks are experiencing a bout of irrational exuberance with respect to a recovery. Bullish advice on China comes to mind in particular.

There is growing momentum behind the idea that many banks are getting the recovery wrong. From Bloomberg: 

Paul Tudor Jones, the billionaire hedge-fund manager who outperformed peers last year, is wagering that Goldman Sachs Group Inc. and Morgan Stanley got it wrong in declaring the start of an economic recovery.

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.

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:

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?

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.

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.

This Week in Crisis

Tyler Cowen claims that a new book on the crisis, In Fed We Trust: Ben Bernanke's War on the Great Panic, is "so far the most entertaining and most readable book on the financial crisis". In typical dramatic fashion that makes Cowen's praise seem subdued, Joseph Stiglitz argues, "no one can understand what happened and what did not happen without reading this book". 

East Asia & Pacific on the rise has two excellent articles on China's economic robustness. The first discusses the growing presence of Chinese firms on the Fortune 500. The second post highlights growing internet use in China, with current figures topping 338 million users.

Supervision, Regulation and the Crisis

In addition to our policy brief on Blanket Guarantees, the World Bank Group has released two more papers as part of the Crisis Response series:

• In Trust Less, Verify More, Clive Briault, director of Risk and Regulation Consulting Limited, argues that financial supervision will need to change in response to the causes of the financial crisis and the regulatory proposals arising from it. Supervisors will need to take a tougher and more challenging approach to the firms they regulate, exercise more supervisory judgment, involve themselves in macro-prudential oversight, and participate more actively in the supervision of firms with crossborder activities. Supervisors in all countries need to take up these challenges—notwithstanding differences in the style of supervision, in culture and legal tradition, in institutional and organizational structure, and in the powers and resources available to the supervisory agency.
  
• In Macro-Prudential Regulation: Fixing Fundamental Market (and Regulatory) Failures, Avinash Persaud, chairman of Intelligence Capital Limited, describes how this is not the first international banking crisis the world has seen. The previous ones occurred without credit default swaps, special investment vehicles, or even credit ratings. If crises keep repeating themselves, it seems reasonable to argue that policy makers need to carefully consider what they are doing and not just “double up” by superficially reacting to the specific features of today’s crisis. While we cannot hope to prevent crises, we can perhaps make them fewer and milder by adopting and implementing better regulation—in particular, more macro-prudential regulation.

Skidelsky, Wolf on Global Imbalances

The most recent issue of the New York Review of Books features an essay by Robert Skidelsky, biographer of Keynes, which discusses Martin Wolf's 2008 book, Fixing Global Finance (itself an excellent summary of global imbalances and the seeds of the crisis). Skidelsky elaborates on the role of the dollar as the world's premier reserve currency, arguing that the dollar's preeminence created a capital glut via the creation of the unofficial "Bretton Woods II" system of fixed exchange rates.

Under Bretton Woods II, many East Asian economies pegged their exchange rates to the dollar in order to build an arsenal of central bank reserves and retain export competitiveness. This buildup allowed the United States government to borrow cheaply and led American consumers to invest in asset-bubbles such as real estate and equities.

Charting a Path out of the Crisis

The World Bank Group (WBG) has just released the first batch of a series of policy briefs on the financial crisis, whose aim is to assess government responses to the crisis, shed light on the financial reforms currently under debate, and provide insights for emerging-market policy makers. The first three papers cover a lot of ground in a short amount of space—sizing up the global policy response, forecasting what future financial systems will look like as a result of these policy responses, and determining how financial regulation will evolve. They will be followed by papers, written by different authors inside and outside the WBG, that will take ‘deep dives’ in specific crisis-related financial sector topics.

• Dealing with the Crisis: Taking Stock of the Global Policy Response provides an overview of the immediate financial sector policy responses to the financial crisis—including emergency liquidity support, expansion of financial safety nets, and interventions in financial institutions—that have succeeded in stemming widespread panic. But the effort has generally been ad hoc and insufficient. Issues that remain include the resolution of problem assets, the restructuring of troubled, systemically important financial institutions, and the development of credible exit strategies. Only a handful of countries have attempted to tackle these issues head-on. As past experience has shown, that may well have negative repercussions for the duration and strength of a subsequent recovery.

• The Reform Agenda: Charting the Future of Financial Regulation reviews the crisis-induced shift toward a tighter and more macro-prudential approach to financial regulation. But the reform agenda still needs to address the role of supervisory (rather than regulatory) failures, while the institutional arrangements needed to implement the new framework remain to be worked out. For most emerging economies, the existing reform agenda—developing institutional and legal underpinnings for the financial system and promoting financial access—remains valid. But for those characterized by weak financial oversight structures and more volatile economic cycles, adopting capital “buffers” as part of a macro-prudential regime may be a useful complement.

• Safe but Smaller? The Shape of Financial Systems to Come describes how global trends taken for granted in recent decades—the big expansion in global financial assets compared with underlying economic activity, growing global financial integration, shrinking role of the state in financial systems, and rising share of cross-border ownership of financial institutions—may reverse over the foreseeable future. In addition, the structure of financial systems, particularly in developed countries, will likely become oriented less toward capital markets and more toward traditional (and simpler) banking activities. The impact on economic growth and overall welfare is likely to be negative—perhaps the price we have to pay for living in a brave new (and presumably safer) financial world.

More Successful Bankruptcy Reforms During Crisis Episodes

I may have to take back what I said about crisis episodes not being optimal periods for reform of bankruptcy regimes. Leora Klapper, a senior economist at the World Bank, informs me in a short article on The Use of Bankruptcy in the Resolution of Corporate Distress that:

Importantly, systemic crisis periods are also periods of great opportunity for meaningful reform that would otherwise be stymied by powerful political interests.  Claessens et al. (2002) provide examples of such reforms from [the] East Asian financial crisis, which include the passage of improved bankruptcy laws in South Korea, Thailand and Malaysia, and the formation of specialized bankruptcy courts in Indonesia and Thailand.  Another example of a successful reform comes from Colombian bankruptcy reform introduced in the midst of a major financial crisis in late 1999. Gine and Love (2008) show that the reform significantly improved the efficiency of the bankruptcy process by streamlining reorganization proceedings.

Bankruptcy Reform: Better Late than Never

Recently, Simeon pointed out the need for a good bankruptcy regime as part of the crisis response: "No matter how successful fiscal stimulus packages and other crisis response measures might be, there will soon be a flow of corporate bankruptcies." Unfortunately, reforms of this magnitude take time to implement, so governments end up resorting to more interventionist measures (as Simeon points out in his post). New research suggests that it's not impossible to reform in the midst of crisis, though.

Writing in the Finance & PSD Impact newsletter, Xavier Gine and Inessa Love report that Colombia managed to carry out a successful reform of its bankruptcy code in late 1999:

Needed Urgently: Good Bankruptcy

As the crisis unfolds, the need for a good bankruptcy regime is starting to dawn on policymakers. No matter how successful fiscal stimulus packages and other crisis response measures might be, there will soon be a flow of corporate bankruptcies. Previous crises show that such bankruptcies lag behind the start of a crisis by a year or two. As demand falls, businesses try to cut expenses, restructure payments, renegotiate with suppliers. Ultimately, many live on. But some fail.

For these, it is useful to have an efficient bankruptcy regime so creditors do not have to write off the whole value of the loan. But bankruptcy is never a popular reform, and governments typically get to it when the courts are already clogged with insolvency cases. By the time a reform is completed, more interventionist options (for example, the use of asset-management companies) are needed.

A recent survey of previous experience in bankruptcy reform suggests a menu of possible reform choices while in crisis. The analysis is to a large extent based on the data from the Doing Business project, and its section on Closing a Business.

Here we present the section on dealing with systemic distress:

Hedging the Fund

On 04.23.09 I attended the second day of a conference here in Washington on “New Ideas in Development After the Financial Crisis,” jointly presented by the Center for Global Development and the School of Advanced International Studies.  A number of the economic illuminati spoke:  e.g., Dominique Strauss-Kahn, Kemal Dervis, Sebastian Mallaby, Santiago Levy, Jose-Antonio Ocampo, Benno Ndulu, Justin Lin and others. 

In this first of two blog posts, I report on the presentation of the Fund’s Managing Director, dealing both with his views on the crisis and how the IMF has changed - and should further evolve - to deal with it.  The second will recount the views of other presenters on what the crisis means for the international financial institutions in general, and the Fund in particular.

What a difference a crisis makes!  Eighteen months ago the IMF was on the ropes.  A highly critical clientele had repaid the bulk of outstanding loans, resources were dwindling, staff were demoralized and diminishing, and there was not much of a purpose in sight.  Today, said Mr. Strauss-Kahn, the need for and relevance of the IMF was “manifest.”  Why?  Because the crisis has shown that “the links between the financial sector and the real economy are deeper” than had been thought, and that “global financial interactions” were both more prevalent and important than foreseen.  The IMF, with its capacity to quickly help poor countries deal with a sudden loss of crucial capital inflows, and middle and high income countries (e.g., Poland, Iceland, Ukraine) cope with crisis and financial collapse, is very much back in business.  Mr. Strauss-Kahn did his commendable best to deplore the dreadful circumstances leading to the Fund’s revival, but I thought I detected the tiniest hint of satisfaction - the IMF is definitely not going under on his watch.

The U.S. as an Emerging Market?

Simon Johnson, a prolific academic writer and former Chief Economist of the IMF, has come out with a relatively negative view on the U.S. financial system, both current and past. According to Simon, the personal interlinkages between the political and financial systems in the U.S. are very similar to those in many, if not most, emerging markets. And the policy approach towards solving the financial crisis has been dominated by attempts to minimize the pain for bankers, rather than for the overall economy. The bank-by-bank approach with generous bail-outs, while avoiding more drastic actions that might risk shareholders’ equity stakes and senior manager bonuses, has not really helped so far. In order to really get out of the slump, Simon recommends more decisive action in the banking sector, including temporary nationalization and clean up of banks, but also the breaking-up of the financial oligarchy with its links to the political system.

Some Recommendations for Dutch Banks

The Dutch banking association recently commissioned a report by an independent committee (including my Tilburg and European Banking Center colleague Sylvester Eijffinger) to draw lessons from the recent financial crisis, which hit the Dutch banking sector quite hard, and formulate recommendations. This committee just released its report. Before you reach for your Dutch-English dictionary, please be assured that the report is actually in English, reflecting the international character of the Dutch academic and financial sectors. 

Some of the recommendations do not surprise, such as better governance structures, remuneration policies that do not award large bonuses if the bank makes losses, and anticyclical capital buffers. Others I find rather difficult to achieve, such as aiming for non-financial targets including customer satisfaction (where Dutch banks have lots of room for improvement, as I can assure you from personal experience). 

Where I am getting really nervous is when too much focus is put on non-owner stakeholders' interests, including employees of banks, or rewarding shareholders who hold on to their shares for at least four years, such as individual shareholders whose shares will probably be voted by someone else through proxy votes. Delinking the ownership structure from the voting structure has rarely fostered efficient banking, as examples from many emerging markets have shown.

Lessons from Past Financial Crises

Can the past teach us anything about the current crisis? Two reports imply as much. A recent report from the Independent Evaluation Group (IEG) of the World Bank looks at Lessons from World Bank Group Responses to Past Financial Crises. According to the folks at IEG:

Experiences with past crises bring out substantial differences in the effectiveness and results of Bank Group crisis support. With important modifications to reflect contextual differences between present and past events, these lessons can inform today’s response and help improve results.

And what can the past tell us about the response of the World Bank, particularly its lending operations?

Effectiveness of Crisis Support. World Bank loans were generally successful in supporting financial and some public sector reforms, but the poverty focus was insufficient. There were attempts to protect pro-poor spending and reduce the poverty impact of the crises (Brazil and Thailand), but overall attention to this area was insufficient. There were also disagreements with the IMF on exchange rate policy (Mexico and Russia), on the scale of macroeconomic adjustment (Indonesia and Thailand), and on what balance to strike between short-term crisis management imperatives and measures to alleviate corporate distress (Thailand). Evaluations also found that the loans were excessively ambitious in the range of problems they tried to tackle and in the large number of conditions they included. In addition, there were problems in several aspects of the Bank’s institutional response to crises. These included poor cooperation between the Bank and the IMF (and with regional banks), as well as among several units within the Bank.

Guerilla Trade Tactics

In 1930, the Smoot Hawley tariff was implemented in the United States, raising tariffs on nearly 900 goods. The Europeans retaliated with similar tariff hikes. World trade fell by two-thirds from 1929 to 1934 largely as a result of declining demand during the world depression, but also because of the increased tariffs. Such conventional trade warfare finally came to an end with the advent of the GATT in 1947.

Thanks to the rules provided in the WTO, the successor to the GATT, a conventional trade war is now unthinkable. But as demand is plummeting, countries are seeking ways to shift it to domestic goods. This is where guerilla trade tactics come in. The WTO Secretariat reported that in the first half of 2008 (the most recent data available) there was a 39 per cent increase in antidumping investigations among members as compared with the same period in 2007. Subsidies around the world are being directed at specific domestic industries. Now, the U.S. stimulus package appears likely to include a “buy American” clause. 

Such guerilla trade tactics may be just as dangerous as a conventional trade war. A key issue is the non-transparency of these antidumping duties, countervailing duties, and targeted domestic subsidies. If these modes of discrimination explode it will take a long time to disentangle them and reopen the trade system. Not to mention the resources wasted and uncertainty they generate for importers (for example, in the United States, it takes the ITC and ITA between 235 to 390 days to reach a final conclusion in an antidumping investigation!). 

The WTO has been among the most successful of the international institutions. The ongoing Doha Round—with all its promises—may be able to claim victory after all if it can simply prevent protectionism from surging during the global recession.

Financial Sector Wages

There is a lot of irritation currently about salaries and bonuses in the financial sector, especially in light of recent bail-outs. Critics of the exuberance in the financial sector should not worry. According to a new working paper by Thomas Philippon and Ariell Reshef, we can expect a sharp decrease in financial sector salaries in the coming years. This prediction is based on an analysis of the wage and skill development in the U.S. financial sector from 1909 to 2006. Until 1933, the financial sector was a high-skill, high wage industry. After the Great Depression, the financial sector not only lost its high human capital, but also the wage premium compared to the rest of the private sector. It was not until the 1980s that the financial sector became yet again a high-skill and high-wage industry, driven by financial liberalization and innovation.

 

Both in the period from the mid-1920s to the mid-1930s and from the mid-1990s onwards, salaries in the financial sector were not consistent with education levels and employment risk, suggesting short-term rents for financial sector employees and an unsustainable labor market equilibrium. So, expect financial sector salaries to drop, although not immediately as the experience from the Great Depression shows, where it took several years for relative financial sector wages to drop. But given excess wages of 40%, expect big drops! These high excess wages might also explain regulatory failures in the run-up to the crisis; regulators could simply not attract sufficient talent given the high excess compensation in the private sector. So, the next question will be: what about the impact on MBA and Finance programs.

Banking and the State

Ample empirical evidence shows that the state is often a poor banker, both in normal times and crises. This is particularly true in less developed countries. Yet, state ownership is mostly prevalent in those countries. This evidence can be easily forgotten as the crisis unfolds.

Financial crises tend to increase state involvement

The severity of the current financial crisis has raised doubts about market effectiveness. As Mr. Greenspan recently pointed out: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity are in a state of shocked disbelief.” States have intervened in unprecedented ways to address fears of insolvency, aimed at safeguarding stability and restarting lending. Direct interventions ranged from massive capital injections (e.g., in UK and US) to bank nationalizations (e.g., Fortis, Glitnir, B&B). Indeed, bank nationalizations are a common intervention tool: they occurred in 57 percent of recent financial crises and future state involvement can be persistent. For example, during the East Asia crisis, assets of Indonesian state banks jumped from 40 to 60 percent of total bank assets. Korea and Thailand experienced similar increases. In these countries, state involvement was still at elevated levels years after the crisis.

When Will Stocks Rebound in Eastern Europe?

Editor's Note: The following is a joint contribution from Simeon Djankov and Facundo Martin. You can also download a PDF of When Will Stocks Rebound in Eastern Europe?

Eastern European stock markets had a traumatic 2008. In several countries, including Bulgaria, Lithuania, Romania and Ukraine, the market indices dropped 75%. In all other countries but Slovakia, stocks lost about half their value.

Will 2009 be different? Do investors have something to look forward to?

Stock market returns depend primarily on the underlying company profits. In emerging markets, these depend on the global economic outlook, as a large share of production goes to foreign buyers. So to know when stocks will rebound, you need to know two things: when the economic downturn will end (both at home and in major export markets), and whether stock prices turn up before or after economic activity picks up.

We study the latest economic forecast by the World Bank to answer the first question. We look at historical data in emerging markets and two developed economies (the United States and the United Kingdom) to answer the second question. In particular, we investigate the relationship between changes in industrial production and changes in stock market indices during previous downturns in six emerging markets (Indonesia, 1997-98; Korea, 1997-98, Thailand, 1997-99; Malaysia, 1997-98; Russia, 1998-99, and Argentina, 2001-02); and the United States (1980-81, 1982-83, 1990-91, and 2001-02) and the United Kingdom (1990-92 and 2001-03).

No Trust Left

While most economists are busy discussing the origins of the current crisis, a few are looking ahead. One nice think-piece is by Daron Acemoglu, of MIT, which draws three lessons. I like the third lesson the most:

The third notion that has also been destroyed by recent events is at first less obvious. It is also one that I strongly believed in. Our logic and models suggested that even if we could not trust individuals, particularly when information was imperfect and regulation lacklustre, we could trust the long-lived large firms - companies such as the Enron's, the Bear Stearn's, the Merrill Lynch's, and the Lehman Brothers's of this world - to monitor themselves and their own because they had accumulated sufficient reputation capital. Our faith in long-lived large organisations was shaken but still standing after the accounting scandals in Enron and other giants of the early 2000s. It may now have suffered the death blow.

If right, Acemoglu is onto something big. Trust is essential to business activity, and losing it may result in bigger cataclysms down the road. For those interested in how trust develops, read Trust in Large Organizations, by my co-authors Andrei Shleifer, Rafael La Porta and Florencio Lopez-de-Silanes.

Crisis Babies?

So, what will be the long-term effects of the crisis on people’s savings and investment patterns?  Will we just go back to business as usual once this is all over?  Not so, according to a paper by Ulrike Malmendier and Stefan Nagel, who studied individuals’ risk attitudes over the period 1964 to 2004.

The average stock market participation rate for the generation that experienced the Great Depression as teenagers or adults is less than half that of all other age cohorts.  In striking contrast, the 1931-40 age cohort that experienced the post-war boom years as young adults has a stock market participation rate almost twice the average.  Judging from that, we can expect a big crisis impact on the financial markets for a long time to come, as much from the demand as from the supply side. 

There is one piece of hope, however.  The data suggest that both recent and past experience counts.  Young households in the early 1980s, having experienced the dismal stock returns of the 1970s, had lower rates of stock market participation than older households for whom the negative experience of the 1970s was moderated by the high-return experience of the 1950s and 1960s.

Does Loose Monetary Policy Cause Crises?

Editor's Note: Thorsten Beck is a former contributor to the PSD blog. Now a professor at Tilburg University, he worked at the World Bank for eleven years and is still involved in activities in the research group and Africa and the Eastern Europe and Central Asia regions. Welcome!

The loose monetary policy in the first years of the 21st century has been one of the culprits for the boom and subsequent bust in the U.S., but rigorously testing this hypothesis is difficult since it is hard to identify cause and effect; the Fed typically lowers interest rates in times of financial fragility and uncertainty, such as after the collapse of Long-Term Capital Management in 1998.

But perhaps we can learn something from a small open economy for which monetary policy decisions can be considered exogenous.  A recent paper by Vasso Ioannidou, Steven Ongena and Jose Luis Peydro does exactly this, using a unique dataset on Bolivian borrowers.  During the period 1999 to 2003, the local currency was pegged to the U.S. dollar and the relevant short-term benchmark rate was the U.S. federal funds rate.  The paper shows that reductions in short-term interest rates do indeed lead to excessive risk taking by banks, which can eventually lead to banking fragility when interest rates rise back to “normal” levels.  So, cheap money is no free lunch and an excessively high variation in interest rates will eventually catch up with you!  These findings emphasize that bank regulation and supervision cannot act independently of monetary policy.

More Weekend Reading

If you've got the time after reading Michael Klein's speech, check out a new working paper from the Commission on Growth and Development called International Finance and Growth in Developing Countries: What Have We Learned? (Hat tip: Dani Rodrik) From the abstract:

...This survey discusses the policy framework in which financial globalization is most likely to prove beneficial for developing countries. The reforms developing countries need to carry out to make their economies safe for international asset trade are the same reforms they need to carry out to curtail the power of entrenched economic interests and liberate the economy’s productive potential.

What's Next for Emerging Markets?

Download Michael Klein's recent speech on the international financial crisis. He discusses the various dimensions of the financial crisis, its effect on developing countries, and how the world's financial architecture may change. Michael is the World Bank Group's vice president for financial and private sector development.

World Bank Research on Past Crises

The World Bank's Development Research Group has just published a working paper on lessons from past crises. It warns of the difficult tradeoffs between rapid crisis response and longer-term development goals.

Hungary Offered Package Similar to Mexico in 1995

The IMF, the World Bank, and the EU have offered Hungary a financing package totalling $25.1 bn -- around 18% of 2007 GDP. This is in line with the package offered to Mexico by the IMF and the US during the Tequila Crisis ($51.8 bn or 18% of GDP) and significantly more than the package made available to Brazil in the 1998 crisis ($41.8 bn or just 5% of GDP). The table below shows additional details:

Book: Resolution of Financial Distress

Time to dust off the East Asia crisis writings. In 2001, I edited a book (with Stijn Claessens and Ashoka Mody, both IMF) on what we learned in the 1998-2000 dealings with financial distress. I had nearly forgotten about this work -- it was rarely cited after it got published. Now you may want to take a look.

The overview is a good start -- it summarizes the findings on insolvency regimes; dealing with systemic distress (asset-managements companies and the like); corporate restructuring; and injecting government equity into troubled financial institutions.

Other good reads are Bankruptcy Laws: Some Basic Principles, by Joseph Stiglitz; Asset Management Companies, by Daniela Klingebiel; and Bankruptcy Procedures in Countries Undergoing Financial Distress, by Michelle White.

A parting thought found on page one of the book: "Broadly in a systemic crisis, the government's role lies, first, in defining rules that would lead to efficient private restructuring efforts and, second, in providing direct assistance where the private initiatives prove insufficient to resolve distress at acceptable output losses."

How Large are IMF Packages Compared to Past Crises?

The IMF has already announced tentative loan agreements with Iceland, Hungary, and Ukraine, and it is working with other countries on a similar direction. The Fund is ready to lend $2.1 billion to Iceland, $15.7 billion to Hungary, and $16.5 billion to Ukraine. These numbers are significant: they represent around 11% of GDP for Iceland and Hungary, and 8% of GDP in the case of Ukraine.

How do these numbers compare with those of similar packages in past crises? As the table below shows, Uruguay received a line of credit of 21% of GDP in the 2002 crisis, and Argentina was offered two packages totalling 8% of GDP in 2000 and 10% of GDP in 2003. Turkey was offered two packages of around 7-8% of GDP each in 1999 and 2002. Most other packages were smaller.

The recent numbers do not include financing given by the World Bank, regional development banks, and other multilaterals. For example, the total package just offered to Hungary totals $25.1 billion from the IMF, the World Bank, and the EU -- or 18% of GDP. In the Asian crisis of 1997-98, if other sources of financing are added (including World Bank and Asian Development Bank money), Indonesia was offered $36.1 billion (17% of GDP), Korea, $58.4 billion (13% of GDP), and Thailand $17.2 billion (12% of GDP).

Currency Depreciation - Reaching the Asian Crisis Levels

The currencies of Malaysia, Philippines, and Thailand depreciated between 40% and 53% during the Asian crisis (a 6-7 month period between mid-1997 and January 1998). Indonesia's currency was the outlier, with a depreciation of 84% in the 12 months from July 1997 to July 1998.

How do these numbers compare with the current crisis? The worst performer since July 2008 has been Iceland--its currency depreciated 51% in less than 4 months (more than Malaysia or the Philippines during the Asian crisis). But other currencies also look bad: South Africa depreciated 38% in less than 4 months; currencies from Hungary, Brazil, Poland, and Turkey have depreciated more than 30% since July; those of Ukraine, Czech Republic, Colombia, Chile, and Mexico have already depreciated almost 30% in the same time period. The pressure on emerging market currencies has been extremely strong in the last few months, in particular since September. If this trend continues, we are likely to see many more countries, across all regions, reaching levels similar to those observed during the Asian crisis.