This was to be expected.  It is an unseemly tooting of ones’ own horn, but –

“The traditional pattern is most clear with the carry from the yen to the euro:  it has been predictably profitable for the last five years, and this will predictably end soon, as the yen reverses its depreciation against the euro.”

Although the phrase “carry trade” became widely popular in the context of currency speculation, where scholars know it as the “forward discount bias,” its etymological root is in commodity speculation.     Broadly speaking, the same phenomenon is observable in housing, equities, commercial bonds, and emerging markets:   when money is easy and nobody is worried about risk (2002-2005), the search for yield sends the excess liquidity surging out of the low-interest currencies, and into all other assets.    When the process reverses, investors pull out of the risky assets and retreat back to the safe haven of the low-interest-rate currencies.   Over the last six months, the reversal of this broadly-defined carry trade hit equities and bonds first, and then commodities (having hit housing earlier, of course).   This month it is finally hitting the high-interest-rate currencies.

The members of the G-20 are meeting in Washington on November 15 to discuss reform of the global financial system.  The first thing to say about the calls for a “new Bretton Woods” is that they overreach, in the sense that it is very unlikely that any changes in the structure of the international monetary or financial system will or should, at this point in history, come out of multilateral discussions that are big enough to merit comparison with the first Bretton Woods. Certainly we are not talking about fixing exchange rates, as the 1944 meeting did.

Detour for an anecdote.  In mid-1998, when the crisis that originated in Southeast Asia had reached its one-year anniversary without abating, President Bill Clinton decided to give two important speeches.   He wanted to call for a new Bretton Woods.   His economic advisers (including both at Treasury and in the White House) advised him against this, on the grounds that one should not call for something as portentous as a new Bretton Woods when one was not likely to have proposals substantive enough to merit the name.   Soon after the (successful) speeches, British PM Tony Blair called for a new Bretton Woods.    Clinton asked his advisers, “How come Blair got to call for a new Bretton Woods when you wouldn’t let me do it?”    Our answer was along the lines, “Blair’s Treasury Secretary, Gordon Brown, doe s not necessarily have his interests aligned with his boss, in the way that Bob Rubin does.   So Brown had less incentive to stop Blair from saying something foolish.”   The big irony of the story is that Brown today is himself leading the move for a “new Bretton Woods.”

Even though the effort is virtually certain to fall short of a true “Bretton Woods 2,” it is worth taking the opportunity to consider what changes – whether more ambitious or less — might be made at the multilateral level to improve the functioning of the system.

Changes in government policy at the national level have already been radical in many countries, compared to anything that would have been imagined a short time ago:
• central banks’ extension of credit to institutions and under terms not contemplated in the past,
• governments’ buying up bad assets and recapitalizing, taking over,, or otherwise transforming troubled banks and financial institutions),
• agencies guaranteeing deposits (without limit) and money market funds, and so on.

Some of these steps can be done at the purely domestic level (US takeover of Fannie Mae and Freddie Mac); others require cooperation between a small number of countries (rescue of Fortis by Benelux countries); but others arguably require multilateral agreement, and thus are candidates for a modest “Bretton Woods.”

•  The International Monetary Fund has been given the task of outlining what a new Bretton Woods would look like – appropriate since the IMF is one of the original Bretton Woods institutions (along with the World Bank).
      o An Early Warning system is almost certain to be high on its list. But it already developed early warning indicators, after the East Asia crisis of 1997-98, and they haven’t been much help.
      o Now that the financial crisis is spreading to small economies like Iceland, transition economies in easternmost Europe, and poor countries like Pakistan, the IMF country rescue programs will get back in the saddle.
           This time around, however, the Fund has more competition (including from the ECB, the Gulf countries, China, and Sovereign Wealth Funds), and partly for that reason will probably demand less conditionality from the borrowing countries.    Also the Fund will have to turn to newly-wealthy countries like China to help finance  new facilities and programs.
              • Bill Rhodes has proposed that the Fund facilitate expansion of currency swap arrangements, to allow emerging markets to have the same access that has been made available to developing countries.
              • Michael Bordo and Harold James have suggested that the Fund could manage reserve assets of the new surplus countries; but it is not clear why the latter should want it to.
          The Contingent Credit Lines (CCL) – which were launched by the IMF with some fanfare in the aftermath of the 1997-98 East Asian crisis but were never attractive enough to attract a single client country — are back now, in the form of  new Short-Term Lending Facility.  The idea has always been that countries that have followed blameless policy (or as far as we can come to that in the real world), as judged by pre-crisis criteria, should be able to borrow large amounts from the Fund very quickly when faced with global contagion, without the usual conditionality.    Brazil and Korea look like two countries that had done most things right in recent years (flexible exchange rates, high level of reserves…) and have nevertheless since September seen international investors disappear.    The IMF has responded appropriately, with CCL-type loans that are multiples of country quotas.  
          Only a small number of countries qualify for having followed “blameless policy.”  Morris Goldstein suggests that the larger class of countries that have now been hit by forces beyond their control — the US-originating financial crisis — be helped by a revival of a long-ago IMF loan window, the Compensatory Financing Facility.
• The problem is that the money that the IMF is now able to offer is not only small relative to global capital markets (the IMF has long been used to that circumstance), but also small relative to the countries’ own reserves or to the no-condition funds that the Federal Reserve has now offered them through swap lines.   To expand such facilities, the IMF needs more funding.  Where will it come from?  Sovereign Wealth Funds and central banks in East Asia and Gulf countries.   But that in turn requires giving these countries much greater political representation than they currently have in the Fund.
              o There has been a loose one-year campaign to suggest guidelines for the operations of Sovereign Wealth Funds themselves, to “regulate” them.  But benefits of the SWFs may be more widely appreciated now than a year ago, in the context of the current crisis.   
              o The IMF, just as all the multilateral economic institutions, has moved far too slowly to give added representation to the newly important developing countries such as China, Brazil, Korea, India and Mexico – representation at least in proportion to their economic role, to say nothing of population.
                  A big part of the problem is that larger quotas and voting shares for these countries would have to come to a substantial extent out of Europe’s share.
                  In a fair world, Europe would also give up its stranglehold on the Managing Directorship (especially after the performance of the recent incumbents, who have appeared less interested in their jobs than in domestic politics back in their home countries or in putting new meaning into the phrase “foreign affairs”).  The same goes for the U.S with respect to the World Bank presidency.

•  The G-8 has been increasingly handicapped in recent years by virtue of its obsolete membership.
      o The G-7 still retains some relevance, in its role as self-appointed steering committee for world governance. After all, this financial crisis did not start in the developing countries, as it did those of 1982, 1997 and 2001.
     o But the G-7 cannot discuss the spread of the crisis to developing countries without Korea, Brazil, Turkey, India and Mexico at the table.  It cannot discuss central topics such as global current account imbalances, or the need for exchange rate adjustments, or coordinated global fiscal expansion, or requests that surplus countries fund rescue programs,  without China and Saudi Arabia at the table.     Thus it is appropriate that the G-20 is the group that has been invited to to the November 15 summit in Washington to discuss the new Bretton Woods.   
     o  Coordinated fiscal expansion is the most likely substantive macroeconomic policy outcome of the G-20 meeting.
      
• A probable substantive structural outcome from talk of the need for a bold new multilateral initiative is that there could be a “Basel III” to replace the “Basel II” agreement.
      o It would make capital requirements on banks countercyclical, rather than what has turned out to be procyclical, i.e., destabilizing, under Basel II. (Ironically economists at the BIS in Basel probably deserve credit for being the observers, in addition to Charles Goodhart, who most accurately warned of the procyclicality before the crisis.)
      o A Basel III could also replace the option of self-regulation of banks (under which they could choose their own Value At Risk models) with external regulation.    Dan Tarullo, who could have a  major role on the Obama team, offers some ideas .
      o The highly capable chairman of the Financial Stabilty Forum, Mario Draghi, assures us that already this year substantial progress has been made in such important areas as reducing conflict of interest on the part of credit-rating agencies.
      o International guidelines for guaranteeing deposits (possibly reinstating a ceiling, such as $100,000, after the crisis has passed) should perhaps be coordinated, to avoid flight of the sort that Ireland’s European partners experienced.

• Other possibilities:
      o A more ambitious reform would be to try to agree on guidelines to extend prudential regulation from international banks to non-bank financial institutions, since the latter were such a serious part of the problem in 2008 that many either failed or were bailed out, against all expectations.
      o More radically, regulation of this sort not just agreed multilaterally but carried out multilaterally, rather than at the national level, by the BIS (which now includes major emerging market countries) or a new agency.
      o The IMF, Financial Stability Forum, and other institutions will vie to lead the effort.
      o Other proposals, many of which could be attempted at the national level, but would optimally be coordinated internationally:
           A securities transactions tax, harmonized internationally, to raise revenue in a way that satisfies the public’s understandable feeling that the financial sector, which created this financial crisis, should not benefit from the solution.
           Executive compensation reform (especially in the financial sector).   Options-based bonuses have not been implemented in the incentive-compatible way that the corporate finance theorists anticipate  d, and have instead encouraged inordinate risk-taking.  One possible solution is to discourage compensation by options, in favor of restricted stock.    Another is to regulate corporate governance so as to insure that the CEO’s buddies don’t comprise the committee that determines his or her compensation.
         Regulation of the “originate to distribute” model of mortgage lending. Mortgage-Backed Securities were a useful innovation, but were carried too far.  The banks or mortgage brokers that originate a mortgage loan should be required to reattain a certain slice of each one (some have suggested 1/5), before selling the rest on, so that they have an incentive to monitor the creditworthiness of the borrower.  
           Regulation of Collateralized Debt Obligations.   Perhaps it is enough to raise capital requirement on the holders.  Perhaps something more drastic is required. 
           Regulation of certain derivatives, particularly Credit Default Swaps.  Perhaps it would be enough to standardize CDSs and set up a central clearing house, as many observers have suggested.
           But there is a danger that derivatives regulation could do more harm than good, e.g., a ban on futures markets or short-selling.
  o At the other end of the spectrum, one should consider the possibility that doing nothing might in the end be better than undertaking fundamental reforms in the international financial system, if the latter were driven by clumsy politics.

[To anyone wishing to post a comment:  I recommend you go to the RGE version of this post.]

I wish to add my heart-felt approval to many others, regarding the awarding of the Nobel Prize in Economics to Paul Krugman.  For those readers of the New York Times who can only think of him as a columnist, let me assure you that long before he ever wrote a newspaper opinion piece, Krugman had become the leading international economist of my generation.  I leave it to others to explain the trade theory research that earned the ultimate accolade.  I will only say that (together with Elhanan Helpman) Krugman took traditional trade theory – which ever since David Ricardo had assumed perfect competition, constant returns to scale, and unchanging technology – and made it more realistic by assuming imperfect competition, increasing returns to scale, and endogenous technology.  

Paul was my classmate in graduate school at MIT in the mid-1970s.    In 1974 I departed my idyllic undergraduate institution for life in the big city (academically speaking).  My college mentor had given me some final words of advice:  not to waste much time worrying about how a position near the top of my undergraduate class would translate to the MIT Economics Department, where all the students had been at the top of their class.  He said,  “My impression is that within a few months of starting the graduate program, the students sort out for themselves who is the top student, the second student, and so on, and then they don’t worry about it from then on.”    As it turned out, it only took two weeks for us to figure out that Paul was the star of the class.   This was clear, not so much from grades on problem sets, but from the intense discussion among classmates that is the core of a good graduate program.

When it came time to write a class skit at the annual MIT Christmas party, we did a parody of the Wizard of Oz.   There was no question who should play the Wizard, who was a parody of Paul Samuelson: our own Paul.    Here are some of his lines, from 34 years ago:

“Though I made a lot of money

No one thought my jokes were funny

‘Til I won the Nobel Prize…”

“So you see you can be winners

even though you are just beginners

When you win your Nobel Prize.”

Congratulations, Paul.   We always knew you would do it !

I propose that the Congressional leadership re-introduce the Trouble Asset Relief Program accompanied by a major new policy: a small tax on securities market transactions. This will accomplish the political goal of aiming a silver bullet into the heart of the (understandable) popular outrage that blocked passage of the TARP bill on Monday. It will simultaneously accomplish the fiscal goal of raising revenue in the future. This is revenue that the federal government would have sorely needed even before the bailout arose and will need even more if the taxpayer is to be protected against the risk of heavily subsidizing the financial sector.

A tax on securities market transactions might sound like a wild populist policy that would damage the functioning of the economy. But in fact it is probably more sensible than such populist measures as banning short sales, which has already been tried (to no avail).

Proposals for financial transactions taxes have a distinguished pedigree, going back at least as far as Keynes.  Best-known is the Tobin tax proposal, by Nobel Prize winner James Tobin, which was specifically aimed at volatility in foreign exchange markets. More relevant to what I am proposing are two articles by the pre-Treasury Larry Summers: “A Few Good Taxes” and “When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax” (1989).   Add to the list of proponents another Nobel Prize Winner, Joe Stiglitz.

There is extensive experience with securities transaction taxes (STTs), especially in other countries.  There have also been quite a few studies of their effects. Often the motivation for such proposals is to reduce short-term speculative turnover:   a tax of 0.1% means nothing to a long-term investor, but is a strong disincentive to those traders who hold their positions for only minutes or hours.  The idea is that reducing short-term speculation will reduce volatility.  On the other hand, defenders of unfettered financial markets often argue that such a tax will reduce liquidity and thus hurt the customers who depend on the market.

The general historical experience seems to be that there is no discernible effect on volatility (though a couple of studies find effects on volatility, either upward  or downward).   In other words, the tax might not help the functioning of the financial markets — the original motivation – but neither does it hurt, according to a majority of the studies.  In some cases the volume of trading within the country is affected.  But what the tax does does usually do is raise money for the Treasury.  

The UK long had a securities transactions tax, known as a stamp duty, which was set at 0.5% in 1986.  Sweden introduced a 0.5 per cent tax on the purchase and sale of equities in 1984 — prompting some financial trading to move offshore – and kept it until 1991.  (Froot and Campbell, studied these two examples in a 1994 book that I edited.   The Swedish case is particularly relevant to the current US context because the popular motivation there was to “take down a peg” high-earning speculators.)    Japan, Korea, Taiwan and Hong Kong have a long history with securities transactions taxes, and India introduced one in 2004; in these cases there were not significant reductions in either price volatility or market turnover.  Other countries that have had financial turnover taxes of at least 0.1% include Australia, Austria, Denmark, Finland, France, Germany, Malaysia, and Singapore.  (Germany abolished its turnover tax in 1991, and Japan in 1999.)   In addition there are other countries that impose smaller fees.

Even the United States had a STT until 1965, and to this day imposes an SEC fee of .0033%.  Thus we have already lost our virginity !

An important potential drawback, if the US were to impose a more substantial transactions tax alone, is that it might drive financial business offshore.   There is an answer to this point.  As noted, many countries already have taxes on financial transactions. Furthermore, lots would love to cooperate with the United States in an international program to harmonize such taxes internationally. This is precisely the sort of project in which many abroad have long asked Americans to participate, but which we have not hitherto wanted to do.

The level and longevity of the tax might be adjusted to achieve the goal of Section 134 of the TARP bill: that the taxpayer recoup the costs of the bailout. A 2004 study by the Congressional Research Service reported that an 0.5% tax on stock transfers could raise $65 billion a year.  Others have produced higher revenue estimates.   A tax extended to bonds and derivatives (especially derivatives!) would of course raise more.   Remember that one does not compare this annual revenue to the $700 billion headline cost of the bailout.  Rather, one compares the present discounted value of the annual flow of revenue to however much of TARP’s $700 billion is left over after the government (we hope) collects something on the troubled loans and also recoups something on warrants obtained from the participating banks.

The tax might on the margin contribute to a shrinking of the size of the financial sector; but this shrinking needs to happen anyway, as Ken Rogoff has pointed out. And most important politically, it would give expression in a non-damaging way to the blood lust that the public feels toward Wall Street, a venting that needs to take place if the bailout bill is going to be approved.

[To any readers who wish to post comments:  I suggest you go to the RGE version of this post.]

When the Treasury came out with its $750 bailout plan on September 22, I  thought it lacked so many necessary ingredients that it deserved a thumbs down.  (Many others had similar objections, including George Soros.)

But in the negotiations between the Treasury and Congressional leaders over the course of last week, most of the missing ingredients were inserted.    Starting with the additions that were most necessary on the merits, and moving toward the ones where the necessity was more political, they were:

·        Institutionalized oversight of the Treasury, which had previously been startlingly absent.

·        Provisions so that the taxpayer would share in the upside potential of banks and other financial institutions, rather than just socializing the losses.  These provisions should allow the possibility that the government could recoup most or all of its short-term losses as has often ultimately been true in past unpopular bailouts.

o       First, by giving the government equity stakes in the banks that sell their bad loans to the Treasury.

o       Second, by having the president in five years submit legislation to recoup the cost from the financial sector if the taxpayer is still in the red at that point.

·        Limits on executive compensation, especially golden parachutes, at banks taking advantage of the opportunity to dump their bad loans on the Treasury.

·        Dividing the $750 billion into three slices over time, which at least offers the congressional negotiators a little bit of cover.

·        A provision for possible government insurance of mortgages instead of acquisition of them.   This was a bone thrown to the Congressional Republicans who had blocked the plan several days ago; I don’t know why they would want this provision, but at least it can’t do much harm.

Some other proposed provisions, from both the right and left, were left out, and for good reason in most cases.

The plan (TARP for Troubled Asset Recovery Plan) would still be unprecedented in magnitude and in the discretion it gives the Treasury Secretary.   Even if the Congress had passed it today, it would not have guaranteed an end to the financial crisis, let alone averting the recession that is probably already inevitable at this point.   Furthermore it does little to begin the reforms in regulation that our financial system now clearly needs.

Nevertheless, and as distasteful as it is to be “bailing out” Wall Street, or even bailing out those homeowners who took out loans that they shouldn’t have, let alone bailing out policymakers who were asleep at the switch, my view is that the program is necessary.   It is better than the alternatives:   

• better than the Treasury proposal of 9/22,
• much better than the proposal we would have gotten from a pre-Paulson Bush Administration,
• better than the alternative that the House Republicans are offering, and (most important of all) 
• better than the alternative of doing nothing, which would (will?) quite likely mean a severe recession.

I suppose it is not surprising that Congressmen facing elections in 5 weeks don’t want to go on record supporting something so unpopular.   What will happen now that the House rejected the deal in its vote today?   Most likely the stock market and real economy will plummet, until the pain gets so bad that a bailout package like this one accumulates more support.

I expressed my views this morning on the NPR radio show On Point.

[To any readers who wish to post comments: I suggest you go to the RGE version of this post.]

In time of war, there is a tendency for both political parties to rally around the president, as we saw (all too well) in Iraq after September 11. In time of financial panic, there is often a similar inclination. The two presidential candidates, for example, are being careful in their statements. I don’t blame them. The issues are too complex to be taken on inside the context of a political campaign. Both candidates realize that the danger of a verbal misstep that the other side can try to blame for worsening the crisis is far greater than the likelihood that either one will come up with a brilliant solution that will gain widespread support or will solve the problem, let alone both.

A panel on Supply Side Economics in Washington, September 12, included statistics on the superior performance of the American economy under President Clinton compared to his Republican successor. (The graph to the right, from Ettlinger & Irons, shows the first term of each administration.  The growth gap during the second terms was even wider.)  Former Treasury Secretary Larry Summers gave some statistics that included Democratic versus Republican presidents throughout the postwar period.   As others have also pointed out, the Democratic record dominates to a surprising extent.   (The event was jointly sponsored by the Center for American Progress and the Economic Policy Institute.)

 By coincidence, in a column in that day’s Wall Street Journal, Donald Luskins sought to “get something settled once and for all. Have the stock markets and the economy historically done better under Democrats or Republicans?”

 These matters are not solely of interest to historians or economists.   The presidential campaign of Senator John McCain appears set to drive its wagon down the same road in which Reagan and Bush have already worn deep ruts.   The candidate is apparently selling the same snake oil:  he says he believes that tax cuts increase revenues.   His principle policy director disavows the Laffer Principle, just as the economists who advised Presidents Reagan and Bush did.   But the views of the economic advisers are not what determines what these presidents do. 

“The Queen in Alice in Wonderland  said that, with practice, she was able to believe as many as six impossible things before breakfast.   Most of us are more limited in our capacity for credulity.  If John McCain believes both the Laffer Proposition (tax cuts raise revenues) and Starve the Beast (higher revenues lead to higher spending, anathema to conservatives), then as a good conservative, his duty is clear.  He ought to run on a truly novel platform of higher tax rates!   Why?   Higher tax rates would reduce revenues (this is what Laffer says would happen) and thereby reduce spending (this is what Starve the Beast says would happen).   
    

Seriously folks.   If McCain continues to propose extending the Bush tax cuts, he should at least be forced to choose between the Lafferite defense and the “Starve the Beast” defense. Only then can the rest of us know which of the two mutually inconsistent propositions to refute. 

I discussed my paper September 12, in a panel where Larry Summers and Gene Sperling also gave their thoughts on Supply Side Economics, at a joint meeting of the Center for American Progress  and the Economic Policy Institute.     

[Any readers wishing to comment on this blog post: I suggest you go to the RGE version.] 

(Incidentally, the July Snowmass presentations regarding Integrated Assessment models of the effects of such emission-reduction policy plans, which I plugged in my preceding blog post, are now accessible to the public.)

But issues of competitiveness and how to address it have risen to the top in the climate change policy debate among politicians.      The Lieberman-Warner bill - would have required the president to determine what countries have taken comparable action to limit GHG emissions;  for imports of covered goods from covered countries, the importer would then have had to buy international reserve allowances – equivalent to a tariff.  (The same with some of the bill’s competitors such as the Bingaman-Specter “Low Carbon Economy Act” of 2007.) 

In theory, there is a possible legitimate role for border adjustments in facilitating a multilateral regime such as the Kyoto Protocol.  One might think of penalties on carbon-intensive imports:

1.      as sanctions to apply pressure on non-participants,

2.      as a calibrated “countervailing duty” to equalize a distortion that will otherwise see carbon-intensive activities migrate to less-regulated countries (a phenomenon known as leakage)   or

3.      as political reassurance to domestic firms worried about their international competitiveness.

If designed properly, they need not necessarily be inconsistent with the WTO (World Trade Organization).    There are precedents, most importantly (and most ironically) the famous/infamous shrimp/turtle case.

But U.S. politicians are unlikely to do it properly.   They may be unaware that the US is more likely to end up as the target of such tariffs than as the enactor – to end up as the defendant, rather than as the prosecutor.   The European Union is way ahead of us in cutting back GHG emissions under the Kyoto protocol, and its EC Directive earlier this year had similar language calling for penalties aimed at shirking competitors.   That’s us.  The difference between their provisions for dealing with shirkers and ours is that their system is already in operation, while for the time being, we are the shirkers.  So US politicians had better look before they leap on this one.

The Brookings Institution had a conference in June that was well-focused on this set of policy issues, organized by Lael Brainard.  Interested readers can link to the papers at Climate Change, Trade and Competitiveness: Is a Collision Inevitable ?    Mine was titled  “Addressing the Leakage/Competitiveness Issue In Climate Change Policy Proposals,” in the panel on Proposals to Deal with Leakages.   

 The issues are reminiscent of larger fears on the part of anti-globalizers — that the WTO and free trade are obstacles to environmental regulation more generally — fears that I think are largely misplaced.   With well-designed multilateral policies, we can work to protect the global environment while simultaneously preserving the economic advantages of free trade.

I am also working on a broader project to address the design of climate change policy architecture as part of the HPICA initiative at Harvard directed by Joe Aldy and Rob Stavins.

[Any readers wishing to comment on this blog post: I suggest you go to the RGE version.]