Someone this week asked me what I thought of policy-makers who ex ante profess a free-market ideology and acute sensitivity to the dangers of moral hazard from financial bailouts, but who toss that ideology overboard when faced with a financial crisis.  The reference was to Treasury Secretary Henry Paulson’s lobbying this week in support of a rescue for Fannie Mae and Freddie Mac, the two big home mortgage agencies, following on the rescue of Bear Stearns in March.   My reply was:  “They say there are no atheists in foxholes.   Perhaps, then, there are also no libertarians in financial crises.”

There are more egregious cases than Hank Paulson of inconsistencies between ex ante promises by policy-makers not to bail out and ex post bailouts when disaster strikes.    (Indeed, some amount of change in position may even be rational for an office-holder, though I would draw the line at false statements.)    I reserve my disdain for those who go around lecturing others on the evils of bailouts, only to out-do the officials they criticized when their own turn in the hot-seat comes.  

An example I have in mind concerns the members of the starting team in the Bush Administration who had lectured the Clinton Administration on the evils of its allegedly excessive bailouts of emerging markets in the 1990s, only to engage in worse when they themselves were faced with the Argentine crisis that began in 2001.  There was no particular reason to rescue the Kirchner government.   Argentina in 2003 would have been the perfect place to refrain from rolling over an IMF program, thereby putting a limit on the moral hazard problem.   The Clinton Treasury had done this with Russia in August 1998 despite high costs in terms of systemic contagion.   Yet the Bush White House continued to push the IMF to bail out Argentina.  Apparently the failing lay in simple inexperience and lack of awareness that any such choices are always difficult.   (See pages 9-11 of my article on Managing Financial Crises, in the Cato Journal, Summer 2007.)    The Administration was very much following in the footsteps of the Reagan Administration, which talked tough at first when the international debt crisis hit in 1982 but which then participated in comprehensive IMF-led bailouts of Latin American debtors who had been pursuing far worse macroeconomic policies than the emerging market governments of the 1990s crises.  

Incidentally, before writing this blog post, I checked into the World War II origins of the sentence “There are no atheists in foxholes.”     I discovered to my surprise that this expression was intended, and is still considered, as a put-down of atheists, and that their lobby protests its use.  

Of course the proposition is not literally true; indeed some soldiers lose their pre-existing belief in God when confronted with the horror of war.   But let us stipulate that those who suddenly face death more often find religion than lose it.  What strikes me as odd is that the expression is apparently normally interpreted as meaning that people who profess atheism don’t really mean it, and that their true colors come out under pressure.     I had, apparently erroneously, thought rather the reverse.   (Indeed, Richard Dawkins argues that vast numbers of people who would no more bet on the existence of God than on the existence of the Easter Bunny, nonetheless call themselves “agnostics” rather than atheists, to avoid rocking the boat.)   

I had always taken the expression to mean that mankind’s hunger for religious beliefs comes from a desperate desire for divine intervention – or, failing that, comfort – when confronting death.  Something more along the lines “There are no unsoiled underpants in foxholes.”     I am in sympathy with the character in a novel who said “That maxim, ‘There are no atheists in foxholes,’ it’s not an argument against atheism — it’s an argument against foxholes.” 

So what’s my point?    Not to argue that governments should intervene always  (nor that they should intervene never).  The lesson for government officials is that wherever they choose to draw the bailout line – one hopes the line strikes an intelligent balance between the short-run advantages of ameliorating a serious financial crisis and the longer-run disadvantages of moral hazard — they should think through the system ahead of time.  They should take the appropriate regulatory precautions during the boom times, which correspond to the bailouts that will inevitably come during the busts.   

Long ago, the United States worked out the approximate right answer for banks:  there will always be rescue of small depositors ex post when banks run into serious trouble, and so under our system, (i) deposit insurance provides formal guarantees ex ante and (ii) banks must pay the price ex ante through reserve requirements, capital requirements, and active regulatory oversight.  What we now need to do is design the analogous sort of system for non-banks.

It should not come as a surprise to high officials that there are such things as financial crises anymore than it should come as a surprise to soldiers that there are such things as bombs.   Human nature must be accepted for what it is.   But in the case of  high officials, it shouldn’t be necessary for them to alter their fundamental beliefs when crisis strikes, in the absence of truly unforeseeable developments.

White House CEA Chairman Ed Lazear expressed confidence to the Wall Street Journal today that the country is not in recession.   I, like Menzie Chinn, am surprised that Lazear is willing to put his reputation on the line in this way.  

It is true that the Commerce Department BEA’s advanced estimate of first-quarter GDP growth was still above zero (+0.6%).     But there are three reasons not to take this number too seriously.
(1) Revisions in these numbers are usually substantial, so the final number could easily turn out to be negative — or twice as high.
(2) Even if the +0.6% number were to hold up, it can be entirely accounted for by measured inventory investment.   In other words, real final demand fell rather than rose in the first quarter.   It is plain that this inventory accumulation was not the outcome of deliberate decisions by bullish firms to add to their inventories in anticipation of a booming economy.   Rather it was almost certainly unintended inventory accumulation, as goods sat unsold on store shelves and in warehouses.    This overhang makes it more likely that inventory accumulation will be negative in the 2nd quarter.   (Admittedly, rising exports from the weak dollar and rising consumption from the tax rebate checks could outweigh that particular factor, and we could scrape along the ground for another quarter at near-zero growth).
(3) As Martin Feldstein has been pointing out (e.g., in the FT), it is a misinterpretation of the GDP statistics to say that growth remained positive in the first quarter.  Rather GDP for QI as a whole was estimated to have been 0.6% higher as compared to QIV as a whole.  The Commerce Department does not report monthly GDP estimates, but MacroAdvisers does, and these data suggest that monthly GDP has been declining since January.

There are other reasons as well to consider it likely that a recession may have started as early as January.     The NBER Business Cycle Dating Committee, which declares when recessions start, looks at lots of data.  But the most important information, alongside GDP, is the jobs data from the Bureau of Labor Statistics.   Employment, like GDP, offers a comprehensive measure across the economy, but it has the advantage of being available monthly and with shorter lags.    The employment data suggest that the recession may have started in January.

It is certainly possible that it will turn out, in the end, that the economy escaped recession in the first quarter.   Even if that is the case, however, it is difficult to be optimistic about the rest of the year.   I can’t remember a time when there have been so many worrisome danger signals:   depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, … . The odds of a recession sometime this year must be rated high.

Fed Chairman Bernanke and Treasury Secretary Paulson have wisely reined in the “happy talk” with which the initial sub-prime mortgage crisis was greeted last  year.   (Remember “the crisis looks contained”?)    If I were Ed Lazear, I would follow their lead.

[Source: Institute of International Finance, Washington, DC]

Continuing on the theme of the unusual spread that banks currently have to pay to borrow from each other since August (due to credit risk and liquidity concerns):  a Wall Street Journal article on April 16, the day after my last post, explained that LIBOR had recently lost some of its reliability.   The true spreads were even higher than what the panels of banks were reporting to the institution that calculates LIBOR, the British Bankers Association (BBA).    Banks can have an incentive to act strategically in the interest rates that they report to the BBA.  Even though the highest and lowest respondents are dropped from the computation, that was not enough of a correction.   But the Wall Street Journal reported the next day that the banks had immediately reacted to this news by increasing the honesty of their interest rate numbers.  The updated version of the LIBOR graph exhibits an upturn in the US interbank rate at the very end.

Good news, in that it suggests that LIBOR is again reliable, which matters because many economically important borrowing rates are keyed off of LIBOR.    But it is also bad news, in that an increase in the official LIBOR then has a contractionary impact on the real economy — again because so many economically important borrowing rates are keyed off of it.   LIBOR has risen about 50 basis points since the last Fed interest rate cut, including 25 basis points in just the last week.   It seems likely that the latter rise is the manifestation of the restoration of LIBOR’s truthfulness.

While some aspects of the subprime mortgage crisis were predictable, the freezing up the most liquid risk-free markets in the world was not.   The illiquidity has been especially striking in the interbank market.    The following chart was kindly made available by the Institute of International Finance, an association of international banks and other financial institutions, in Washington, D.C.    Their Capital Markets Monitor reports in April: “Credit and equity markets have recovered somewhat, after a series of central banks’ moves to provide liquidity and safeguard systemic stability. However, tension in term interbank markets remains.”

I see three interesting lessons from the chart. 

·        The most important one, of course, is simply that the spreads shot up so abruptly last August, and that they remain very high.    The have come down twice, most sharply in response to central bank measures in December-January, but they have also relapsed twice.  It is extraordinary that even large banks are still so uncertain of their environment that they are reluctant to lend to each other.    Not a good sign. 

·        The second interesting point one might glean from the chart is that each of the three times that the spreads have risen sharply over the last year, the spread in the UK has gone up somewhat more than the Euroland spread, with the Fed somewhere in between.   One might use these differences to pass invidious judgment on how well the three central banks have handled the crisis.    

·        The third point, which dominates the second, is that the correlation across countries is very high.   The three lines overall move closely together.   This means that even though the interbank market has broken down in an important way that we did not think could happen, the banking system internationally is as tightly linked as ever.   Contagion is everything.   Even though the problem originated in the US (the sub-prime mortgage crisis last summer), you couldn’t prove it by this graph !