Greg Ip

Articles by The Economist’s U.S. Economics Editor

Posts Tagged ‘Financial crisis

We’re Borrowing Like Mad. Can the U.S. Pay It Back?

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By Greg Ip
Sunday, January 11, 2009; B01
From The Washington Post Outlook Section

In its battle against the financial crisis, the U.S. government has extended its full faith and credit to an ever-growing swath of the private sector: first homeowners, then banks, now car companies. Soon, President-elect Barack Obama will put the government credit card to work with a massive fiscal boost for the economy. Necessary as these steps are, they raise a worry of their own: Can the United States pay the money back?

The notion seems absurd: Banana republics default, not the world’s biggest, richest economy, right? The United States has unparalleled wealth, a stable legal tradition, responsible macroeconomic policies and a top-notch, triple-A credit rating. U.S. Treasury bonds are routinely called “risk-free,” and the United States has the unique privilege of borrowing in the currency that other countries like to hold as foreign-exchange reserves.

Yes, default is unlikely. But it is no longer unthinkable. Read the rest of this entry »


A fiscal nightmare and opportunity for Obama

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Waiting for God-only-knows-what

Jan 8th 2009 | WASHINGTON, DC
From The Economist print edition0209us4


Rex Features

America’s grim fiscal outlook could either be a nightmare or an opportunity for Barack Obama

DURING one of his debates with Barack Obama, John McCain, the Republican candidate, kept referring to the “fiscal crisis” when he meant “financial crisis”. Perhaps he was on to something.

On January 7th the Congressional Budget Office (CBO), a non-partisan outfit, released projections that show the financial crash and the resulting recession are already wreaking havoc with America’s finances. It reckons that the budget deficit will soar from $455 billion in fiscal 2008 (which ended last September 30th) to an astonishing $1.2 trillion in the current year. At 8.3% that would be the most as a share of gross domestic product since the second world war. (The CBO does, however, see it dropping to 1.1% of GDP by 2019.)


The reality is both better and worse than these numbers imply. Of this year’s total, $420 billion represents the one-off subsidy implicit in the Treasury’s planned $700 billion of injections of capital and loan guarantees into the financial system and its “effective” guarantees of the two big mortgage agencies, Fannie Mae and Freddie Mac. Neither is a cash outlay in the usual sense.

But the underlying picture is worse for several reasons. First, it does not include any estimate of the cost of Mr Obama’s planned fiscal stimulus, which he will seek from Congress soon after being inaugurated. Second, the CBO assumes all of George Bush’s tax cuts will expire as scheduled at the end of next year and that the Alternative Minimum Tax, a parallel levy aimed at the wealthy, is allowed to ensnare a growing share of the middle class each year. True, that is what current law, as opposed to current practice, lays down; but neither is at all likely to happen. (The AMT has repeatedly been “patched” to lessen its baleful effects, and surely will be again.)

But the real problem is that the first baby-boomers retired last year. In coming decades spending on entitlements—the three main ones being Social Security (pensions), Medicare (health care for the elderly) and Medicaid (health care for the poor)—will drive deficits and so debt up sharply. Publicly held debt will climb from 41% of GDP last year to 54% next year, the CBO predicts, then decline (on the assumption that the recession will start to come to an end). But the CBO has previously said that, as America ages and if current policies continue, it could theoretically hit an otherworldly 400% by mid-century.

The situation sounds like a nightmare for Barack Obama. The figures hang over his negotiations with Congress on a fiscal stimulus plan. As currently envisioned, it would include business and individual tax cuts and, for those who pay little or no tax, tax credits. That would include a $500 per worker or $1,000 per household credit that was a centrepiece of Mr Obama’s campaign. It would include substantial funds for public works spending, additional Medicaid funds and other aid for cash-strapped states, and money to broaden the availability of unemployment insurance and provide health benefits to the unemployed. On January 7th Mr Obama said the package would be at the high end of estimates—which his team had previously pegged at $675 billion to $775 billion over two years—but not as high as some economists have urged.

Mr Obama faces three sceptical constituencies: Republicans, fiscal conservatives in his own party, and the markets. The addition of so many tax breaks to the package appears to have won over the co-operation of Republican leaders, although lengthy negotiations remain.


Fiscal conservatives are resigned to a big expansion of deficits in the short term but they want an early commitment to deal with entitlements as well. This is where the confluence of the economic and budgetary crises creates an opportunity. Since Mr Bush’s tax cuts expire at the end of next year, Mr Obama could try to reform the tax and entitlement systems simultaneously, which makes economic sense since so many aspects of health care and retirement impact the tax code.

Politically, a reform that antagonises so many constituencies is hardly appetising. “When you start making choices, you start losing friends,” says Kent Conrad, the Democratic Senate Budget Committee chairman and a leading fiscal hawk. He argues the job should be handed over to a bipartisan task force. But Thomas Kahn, the top staffer on the House Budget Committee, notes that some legislators worry that such mechanisms undermine the democratic process by limiting the opportunity for amendment and debate.

For his part, Mr Obama has acknowledged the urgency of addressing entitlements, but said more specifics would have to await his draft budget proposal, due for submission in mid-February. He has aimed his anti-deficit rhetoric, both before the election and since, principally at waste and earmarks, the pet projects legislators insert into spending bills. But as Maya MacGuineas of the Committee for a Responsible Federal Budget, a watchdog group, notes, such spending is at most $30 billion a year, or 1% of total expenditures. By contrast, entitlements amount to $1.2 trillion, or 41% of the whole; and, left unreformed, will grow to 60% by 2030.

Still, Ms MacGuineas thinks Mr Obama has to start with waste and earmarks to build the necessary credibility for bigger steps. “Before you say, ‘Ladies and gentlemen, your Social Security and Medicare benefits are going down and your taxes are going up,’ they want to know there are no more bridges to nowhere.”

Will the markets co-operate? Since November stock and credit markets have rallied partly as previous initiatives gain traction and partly in anticipation of more aggressive actions by the incoming administration. Record deficit projections have not spooked investors: the dollar has strengthened as the overseas outlook turns grimmer, and deflation worries have driven Treasury yields to their lowest in over half a century. But as financial panic subsides, the prospect of huge current deficits combined with the coming entitlements crunch could cause investors to worry America will one day inflate its way out of the debt or even, in the extreme, default. The resulting higher interest rates would elevate the cost of servicing the federal debt, further aggravating the deficit. The threat of such dangerous debt dynamics is ample incentive for Mr Obama to hurry up and explain how he will tame the deficit once the recession is over.

We need a new regime for handling financial failure – now

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Barack Obama’s BlackBerry

Subject: Wall Street

Dec 30th 2008
From The Economist print edition


Another look inside the president-elect’s BlackBerry, soon to be confiscated on security grounds



“FIRST the good news. While the recession is getting worse, the financial crisis that started it has been contained—for now. The government has had to bail out only one big financial institution in the past six weeks.

The bad news is that the Bush administration and the Fed had nothing resembling a consistent strategy. They crushed Fannie’s and Freddie’s stock holders. They saved Citigroup’s. Ad-hockery is costly: it keeps private capital on the sidelines for fear of being wiped out in the next Sunday night rescue. And the government is now on the hook for perhaps trillions of dollars of guarantees and new capital, in return for which it got no extra power to protect the system and the taxpayer in the future.

What we need, and soon, is a “resolution regime”, governing how the government may take over any big financial institution and sell, nationalise or close it. We do have such a regime for deposit-taking banks, but it’s flawed in two respects. First, huge amounts of money are sloshing around outside the banks. Second, the biggest banks have long since become so thoroughly intertwined with the financial system that they cannot be neatly closed down as our laws once envisioned.


Designing such a regime is going to be a lot harder than just saying we need one. How are we going to decide which institutions are so important that they must come under it? And any institution we do agree to cover will be seen as “too big to fail”, obtaining an unfair advantage over its competitors in their cost of borrowing.

Whatever we come up with, voters have a right to be sure that we never get into this kind of mess again. The inability of the Republicans to forestall or fix the crisis was the main reason you won (after your charm and brains, naturally).

At a minimum, we will need much tighter federal oversight of the non-banks, and that is going to be hugely unpopular with Wall Street (though a bit of squealing from them is no bad thing for voters to hear). This ought to be part of a broader overhaul of a financial regulatory system that everyone knows is a mess: we have seven agencies overseeing banking, securities and futures and they still allowed the banks to behave like lunatics and failed to spot Bernie Madoff’s Ponzi scheme. It took four years to pass the last overhaul. We don’t have that much time: the crisis could claim its next victim at any moment. We have to figure out, right now, how we will respond.”

Written by gregip

January 1, 2009 at 10:00 pm

Will the Fed’s unconventional monetary policy work?

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Ground zero
Out of conventional ammunition, the Fed uses its balance-sheet to battle the slump
CENTRAL bankers ordinarily strive to be boring. But these are not ordinary times. On December 16th the Federal Reserve unveiled a three-part assault on America’s slump that lit up the news wires like a pyrotechnic display.

Dec 18th 2008 | WASHINGTON, DC
From The Economist print edition


The Fed’s policy panel, the Federal Open Market Committee (FOMC), announced that it had cut its target for the federal funds rate to between zero and 0.25%, the lowest on record; it indicated it would stay there “for some time”; and having used up its conventional monetary firepower, it promised an unconventional strategy, such as the buying of mortgage-related securities and, possibly, Treasuries to lower long-term borrowing costs.


There was in fact less novelty than first met the eye. The actual funds rate, which is charged on excess reserves banks lend to each other overnight, had already fallen to below 0.2% (see chart), well below target, in part because the banking system is awash with unneeded reserves. (The FOMC is now aiming at a range rather than a level because of the difficulty of hitting the latter.) The Fed had already announced plans to buy up to $100 billion of debt directly issued by Fannie Mae and Freddie Mac, the now-nationalised mortgage agencies, and $500 billion of their mortgage-backed securities (MBSs). Ben Bernanke, the Fed’s chairman, had said Treasury purchases were under consideration.

But drowning out the specifics was the thundering tone of the Fed’s long statement. “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” it said.

Unconventional monetary policy is often called “quantitative easing” because its effect is felt through the quantity rather than the cost of credit. Through an array of lending programmes, the Fed’s balance-sheet has soared from below $900 billion to more than $2 trillion, and is about to grow further.


Will these tactics work? In an exhaustive study of unconventional monetary-policy options in 2000, five Fed staff economists concluded, “These tools have their limitations, and there is considerable uncertainty regarding their likely effectiveness.” The impact of the Fed’s actions to date even on short-term interbank rates is inconclusive; its ability to influence much larger, globally integrated bond markets is even less certain. Still, Vincent Reinhart, who studied such policy options while at the Fed and is now at the American Enterprise Institute, a think-tank, believes they will work if they are big enough. “There is some size of the central bank’s balance-sheet that will restart financial markets.”

The Fed seems to believe its actions matter more for psychology than in influencing the supply of and demand for long-term debt. A senior official says the Fed is not explicitly attempting to lower long-term rates; instead it wants to narrow the unusually wide spread between yields on MBSs and Treasuries. By reassuring investors that a committed buyer is in the market, it hopes to reduce the illiquidity premium pushing yields up.

Psychology does seem to matter. The Fed has not yet bought any MBSs, but their yields have dropped from 5.45% to 3.9% since it proposed doing so. One-quarter of a percentage point of that came after this week’s announcement. If this is sustained, the conventional 30-year mortgage rate should fall to around 5%, says Nicholas Strand of Barclays Capital, from over 6.5% in early November. Still, over two-thirds of the drop in MBS yields resulted from falls in Treasury yields. Even though the Treasury now explicitly supports Fannie and Freddie, MBS spreads remain wide, owing in part to reduced buying by the companies themselves and by foreign investors, Mr Strand says.

Illustration by S. Kambayashi

Amid falling consumer spending and soaring unemployment there are some hints that policymakers’ actions are making a difference. Home sales are stable and the drop in mortgage rates should help them. A bottom in housing is probably necessary to start the healing process elsewhere in the economy. Share prices have risen since late November.

The Fed’s gung-ho leadership may also nudge other central banks towards easing more aggressively. The dollar fell sharply, particularly against the euro, after the Fed’s action. That may weaken the European Central Bank’s reservations about cutting rates again. Similarly, if the weaker dollar takes pressure off sterling, the Bank of England may be more willing to ease again.

The dollar’s drop may also reflect some fear that the Fed will be slow to reverse course, leading to inflation. That, however, is a worry for another day. Falling petrol prices triggered the largest monthly drop in American consumer prices on record in November. With unemployment likely to increase further, the immediate concern is that inflation could fall too low.

Understanding unorthodox economic policies

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Plan C

Nov 27th 2008
From The Economist print edition



As their economy slides, America’s policymakers are turning to unconventional devices. Our first article looks at the bold new steps taken this week by the Federal Reserve and the Treasury. Our second examines policy in Europe

Illustration by James Fryer


THE Federal Reserve’s interest-rate target is at 1%. The recession is deepening. And the question is being asked repeatedly: when will America’s economic policymakers start using truly unconventional measures to stimulate the economy?

The answer is that they already have. Without making any formal declaration, since early September the Fed has expanded its balance-sheet rapidly to counter the credit crunch. Under the guise of successive new programmes, each with a less memorable acronym than the last, the Fed is substituting its balance-sheet for that of the contracting private financial system to keep the American economy from being starved of credit. This week the central bank and the Treasury unveiled their latest big initiatives.


America’s financial system is undergoing a radical reassessment of what are acceptable levels of capital, leverage and interest rates. Some institutions have failed; those that have not are intent on reducing their leverage (ie, their volume of loans for each dollar of capital). The Fed has no hope of stopping this: it is merely trying to slow it down, by providing a home for the assets that the financial sector is shedding. The alternative would be plunging asset values, a complete withdrawal of credit and economic catastrophe.

Ben Bernanke, the chairman of the Fed, has repeatedly promised to use “all of the powers at our disposal” to get credit flowing again. This week’s initiatives are another demonstration of what he means. The Fed and the Treasury agreed to guarantee $306 billion-worth of assets belonging to Citigroup (see article). They then created a $200 billion facility to purchase asset-backed securities. Most radically, the Fed promised to buy up to $500 billion-worth of mortgage-backed securities (MBSs) guaranteed by government-sponsored enterprises (GSEs), including the now nationalised mortgage agencies, Fannie Mae and Freddie Mac, and up to $100 billion-worth of their direct debt. The effect was immediate: yields on the securities plunged by 40 basis points, and the 30-year mortgage rate fell from a shade over 6% to 5.8%.


Paying the Fed

The MBS purchases are significant; for the first time they turn the Fed into a direct lender to consumers. Many homeowners, though they do not know it, will be sending their monthly mortgage payments to the Fed. The Fed will finance these programmes with newly created reserves: that is, it will print money. Its balance-sheet, which has ballooned from $900 billion to $2.2 trillion since August, could grow by another $800 billion, making it a larger lender than any commercial bank.

It is tempting to look to Japan for a map of where the Fed may be heading next. Faced with sinking asset prices, insolvent banks, moribund growth and deflation, the Bank of Japan (BoJ) eventually lowered its policy rate to zero in 1999. In 2001 it announced “quantitative easing”: through large-scale purchases of government bonds, it would fill the banks with excess reserves that it hoped they would lend out, stimulating loan growth.

These routes are open to the Fed. It could cut its federal funds rate target from 1% to zero, though that would make it hard for some parts of the money market to function. It may not do much good, since the actual funds rate is already trading well below the target. To give it more impact, the Fed could commit itself to keeping the funds rate at zero for some time or until the economy or inflation meet some predetermined conditions. Such a commitment could drag down long-term Treasury-bond yields. Academics have concluded that Japan’s quantitative easing had little benefit except to buttress expectations that its policy rate would be zero for a long time. Alternatively, the Fed could target long-term rates via purchases of Treasuries, as it did from 1942 to 1951. That strategy could gain in appeal if big government deficits start to press bond yields higher.

Yet these options are not the most appealing for the Fed. The reason is that while it, like the BoJ, is now involved in a form of quantitative easing, it is doing so with completely different goals and in a very different environment.


One way to see this is to compare Japan in April 1995, when the BoJ’s policy rate was 1%, with America in October (see chart 1). Core inflation was slightly negative in Japan at the time, against 2.2% in America last month. That means real interest rates were significantly higher and conventional monetary policy less stimulative in Japan than in America today, says Tom Gallagher of ISI Group, a broker-dealer, who made the comparison.


Frozen by fear

Where America fares worse is in credit conditions. In 1995 Japanese corporate-bond yields were just 16 basis points higher than government-bond yields; the spread in America last month was 350 basis points. In a nutshell, Japan’s problem was deflation and moribund investment; America’s is rising fear of default, illiquidity and the need of so many lenders to reduce leverage, which collectively are choking off private credit and blunting conventional monetary policy. Although the federal funds rate target is far below the 5.25% of last summer, mortgage rates are only a little lower (see chart 2). Corporate borrowing rates are much higher.


The change in the perception of credit risk since the crisis began is similar to the change in the perception of terrorism risk after September 11th 2001. What investors once deemed safe levels of capital and liquidity they now consider dangerously thin. Before, banks “had just-in-time capital available, just-in-time funding…a lot of liquidity,” Vikram Pandit, Citigroup’s chief executive, said this week, “We’ve gone from that to, if you really need sizeable funding, you have got to go to a central bank. If you need to raise a lot of debt, you need an FDIC guarantee.” (The FDIC, or Federal Deposit Insurance Corporation, is a bank regulator.) Citi’s assets, which peaked at $2.4 trillion a year ago, were down to a little over $2 trillion by the end of September. With the Treasury’s injection of equity this past week, Citigroup’s core capital is now almost 15% of total assets, once an astronomically high ratio but one that many banks will now be expected to attain.

The pressure on investment banks to reduce leverage is even greater, because they rely more on fickle wholesale funding and less on stable, federally insured deposits. As a firm that depended heavily on proprietary trading and underwriting, Morgan Stanley boasted $33 of assets for each dollar of capital a year ago. By the end of October, the leverage ratio was below 16, according to the company. To get it there it both raised new capital (from sources including the federal government) and shrank its balance-sheet, to “significantly less” than $800 billion by the end of October from more than $1 trillion in May. “Clearly we’re in a world of reduced leverage,” Colm Kelleher, the firm’s chief financial officer, told investors recently.

The deleveraging of firms like Morgan Stanley and Citigroup creates problems for borrowers throughout the economy because the yields on the assets they sell rise. Borrowers must fight for a shrinking supply of new credit. Those that get it must pay far more. The rest cancel investments, lay off employees and hoard cash.

Initially Mr Bernanke sought to ease the pressure to deleverage by offering to finance banks’ holdings of illiquid securities on easy terms. But investors began to question the ability of bank capital to withstand a wave of recession-related defaults. The Treasury’s Troubled Asset Relief Programme (TARP) aims to quell those fears by injecting equity into banks so that they can reduce their leverage without shrinking their balance-sheets.

However, there are limits even to this. The Treasury has stuck to purchasing preferred equity to minimise the risk of loss and avoid having any say in running the bank. But the high interest rate the Treasury receives on such stock reduces banks’ profits. And rating agencies and regulators consider preferred stock a less permanent and therefore inferior form of capital to common equity.

Simon Johnson, an economist at the Massachusetts Institute of Technology, thinks the Treasury should start purchasing common equity instead, as the British government has done. With banks’ market values so low, that would leave the government with large stakes, and perhaps majority ownership of some banks. Mr Johnson suggests creating an arm’s length control board to oversee the government’s ownership, free of political meddling.

Still, helping banks recapitalise only partly mitigates deleveraging. Many large buyers of debt assets have simply disappeared, such as “structured investment vehicles”, or SIVs, that used short-term financing to buy up asset backed securities, often from banks seeking to free up capital. At one point they held up to $400 billion in assets. But, unable to roll over their funding, they have been either reabsorbed by banks or closed. In October one of the last big SIVs, Sigma Finance Corporation, with $27 billion in assets, collapsed. Its liquidation by creditors is thought to have contributed to the plunge in prices of asset-backed securities which has made it impossible for new securities backed by student, credit-card and car loans to be issued.

When the average person hears the term “asset-backed securities” he may well think of some of the crazier structures built on the rickety base of subprime mortgages. That would be wrong. Securitisation is decades old, mundane and vital. Banks and other lenders routinely pool their student, car, small-business and credit-card loans, and residential and commercial mortgages into securities and sell them to investors, leaving room for them to make new loans. The deleveraging of banks may be inevitable and healthy, but the disappearance of the securitisation market is not. Without it, “millions of Americans cannot find affordable financing for their basic credit needs,” Hank Paulson, the treasury secretary, said on November 25th. The facility he and the Fed unveiled that day will buy up to $200 billion of newly issued, top-rated asset-backed securities. The TARP will absorb the first $20 billion of losses; the Fed will lend the rest. It may eventually purchase commercial and residential MBSs that are not guaranteed by a GSE.

The facility may thus eventually do what TARP was meant to: relieve banks of their illiquid assets. But it does so by in effect leveraging each TARP dollar many times over via the Fed’s balance-sheet. “Policymakers seem to have concluded that leverage got us into this mess and leverage can get us out,” quipped Stephen Stanley, an economist at RBS Greenwich Capital. “Is it just me, or can you see a future for these guys running a hedge fund?”

The Fed’s decision to purchase MBSs is in some ways even more radical: it represents a direct foray by the Fed into lending to consumers: Though it has had the authority to buy the MBSs and debt of Fannie Mae or Freddie Mac since 1966, it has not done so since 1997 for fear of conferring government backing to ostensibly private companies. Those concerns disappeared when the Treasury in effect nationalised the companies in September.

Illustration by James Fryer

The Treasury and the agencies themselves had been buying MBSs but in spite of that the yields continued to rise, in part because of the government’s mixed signals on whether it stood behind the companies. The Fed’s announcement carries clout because of the size. There is no reason why the Fed need stop at $500 billion; between them, Fannie and Freddie have $4 trillion of MBS outstanding and $17 billion of their own debt. In going further, the Fed would in effect take over the roles of the mortgage agencies itself. And in theory, it could find creative ways to do the same for the corporate-bond market. Mr Bernanke is willing to try almost anything.

Yet these strategies do carry risks. One is inflation. Having expanded its balance-sheet so rapidly, the Fed may not have the foresight or courage to shrink it fast enough once the crisis passes, and the extra liquidity could fuel an overheating economy. But with unemployment perhaps heading for 9%, from 6.5% now, that risk seems remote.

Another risk is that the Fed and the Treasury have taken on more commitments than they can credibly keep. With budget deficits that could top $1 trillion a year, plus trillions of dollars more in guarantees to mortgages and bank debt, some investors may question America’s ability to shoulder all this debt. They could react by selling the dollar, although with the entire world in recession, the lack of appealing alternatives makes that less plausible.

More likely, they could just back away from Treasury bonds until the yields rise enough to compensate them for the higher risk of default. Ireland represents a cautionary tale: since it guaranteed the debts of its banking system, credit-default swaps have widened sharply on its sovereign debt, implying rising concern that the Irish government may one day default. America is a much bigger country and its currency happens to be the world’s premier reserve currency. So it can print as much as it likes. For now, anyway.