“How Efforts to Avoid Past Mistakes Created New Ones: Some Lessons from the Causes and Consequences of the Recent Financial Crisis”

In the first chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Sheila Bair and Ricardo Delfin argue that regulatory responses to past crises sow the seeds of the next ones:

  • The “Greenspan put” fostered risk-taking and overconfidence.
  • Low interest rates and the search for yield led to a lowering of lending standards and stronger demand for mortgages; a rise in housing wealth accompanied falling household incomes. The Fed’s strong policy response to the Great Recession may create new risks.
  • The 1980s savings and loans crisis led to stronger reliance on the originate to distribute model and securitisation of mortgages. Market participants lost sight of the risks. Regulatory incentives led banks to take the securitised loans back on their balance sheets and additional sources of maturity mismatch arose from strong reliance on short-term funding.
  • The “self-correcting markets myth” led Congress to deregulate financial services. The Gramm-Leach-Bliley Act fostered competition and consolidation; the Commodity Futures Modernization Act loosened oversight over the OTC derivatives market. Financial regulators also relaxed restrictions; Basel II replaced standardised regulator-set capital charges with internal models of banks.The Dodd-Frank Act reversed this trend, allowing for more discretion and micro-management.
  • The pre-crisis incentives led to large, “too-big-to-fail” institutions and bred moral hazard. Dodd-Frank improve things, by establishing consolidated oversight, living will requirements, enhanced prudential standards and enabling the FDIC to resolve systemic entities that cannot be resolved safely in bankruptcy. Clearing houses may require more regulation.

Perspectives on the Financial Crisis

A Hoover Press book edited by Martin Baily and John Taylor collects articles about the financial crisis. The contributions in “Across the Great Divide: New Perspectives on the Financial Crisis” include (with links to PDF files):

Myopia in East Asia

The Economist reports about a rising share of teenagers in East Asia that suffer from myopia.

The biggest factor in short-sightedness is a lack of time spent outdoors. Exposure to daylight helps the retina to release a chemical that slows down an increase in the eye’s axial length …

Once they start school, Chinese children spend about an hour a day outside, compared with three or four hours for Australian ones.

The ECB and Ireland: Bailout But no Bail-In

Vincent Boland and Peter Spiegel suggest in the FT that the ECB coerced Ireland into applying for a bailout in 2010, based on letters recently released by the ECB. The ECB, in contrast, argues that the bailout was unavoidable anyway, and that the Irish Minister for Finance shared this view. In a Q&A section on its website the ECB writes:

While the ECB always acted within its remit and in line with rules established for the whole of the euro area, there are limits to the support that the Eurosystem can provide to banks in the Member States. … First, collateral has to be adequate; and second, counterparts have to be financially sound and solvent. The letter dated 15 October 2010 from the former ECB President recalled these rules and their implications for Ireland. … [Another letter dated 19 November 2010] explained the conditions under which further provisions of ELA to Irish financial institutions could be authorised. In his already public reply of 21 November 2010, the Irish Minister for Finance stated that he fully understood the concerns raised by the ECB Governing Council.

The ECB also addresses the question why it opposed the bail-in of bondholders in 2010:

As regards the possible bailing-in of senior debt in late 2010, it is important to recall the words of EU leaders in a European Union statement of 29 October 2010 and during the G20 meeting in South Korea on 12 November, according to which burden-sharing of senior debt would not be applied until mid-2013. … Furthermore, the necessary EU governance tools to address the bail-in of creditors, which were set out in the Bank Recovery and Resolution Directive (BRRD) and have been fully endorsed by the ECB, were not available in late 2010. … any potential burden-sharing of senior debt in the immediate aftermath would first and foremost have had negative spillover effects on the financial stability of Ireland, as well as on other European countries.

 

 

Luxembourg’s Tax Agreements with International Companies

The International Consortium of Investigative Journalists reports about the tax agreements between Luxembourg and major international companies that helped these companies avoid taxes. The Consortium’s key findings:

Pepsi, IKEA, AIG, Coach, Deutsche Bank, Abbott Laboratories and nearly 340 other companies have secured secret deals from Luxembourg that allowed many of them to slash their global tax bills.

PricewaterhouseCoopers has helped multinational companies obtain at least 548 tax rulings in Luxembourg from 2002 to 2010. These legal secret deals feature complex financial structures designed to create drastic tax reductions. The rulings provide written assurance that companies’ tax-saving plans will be viewed favorably by Luxembourg authorities.

Companies have channeled hundreds of billions of dollars through Luxembourg and saved billions of dollars in taxes. Some firms have enjoyed effective tax rates of less than 1 percent on the profits they’ve shuffled into Luxembourg.

Many of the tax deals exploited international tax mismatches that allowed companies to avoid taxes both in Luxembourg and elsewhere through the use of so-called hybrid loans.

In many cases Luxembourg subsidiaries handling hundreds of millions of dollars in business maintain little presence and conduct little economic activity in Luxembourg. One popular address – 5, rue Guillaume Kroll – is home to more than 1,600 companies.

Hybrid loans combine the advantages of interest bearing debt and dividend paying stock. Profits are treated as interest payments (deductible for tax purposes) in Luxembourg and as profits (eligible for tax exemption) in the parent company’s country.

Hayek’s “Why I am not a Conservative”

Cass Sunstein interprets Friedrich von Hayek’s “Why I am not a Conservative” in BloombergView.

According to Sunstein, Hayek endorsed Conservatives’ skepticism about rapid change and social engineering and appreciated their understanding of the value of institutions that grow out of decentralised interaction rather than centralised social design. At the same time, Hayek saw Conservatives as objecting to novelty as such and complained that they did not “welcome the same undesigned change from which new tools of human endeavor will emerge.” And he complained that they are far too fond of established authority (“The conservative does not object to coercion or arbitrary power so long as it is used for what he regards as the right purposes.”) and have difficulty cooperating with people who don’t share their moral values. Sunstein: Instead of conservatism, Hayek argued for a principled commitment to liberty, “directed against popular prejudices, entrenched positions and firmly established privileges.”

The IMF Favours Fiscal Stimulus over Prudent Fiscal Policy—Or Not?

Robin Harding reports in the Financial Times about the IMF’s critical review of its own policy recommendations in 2010. The IMF’s independent evaluation office commends the fund’s lending at the time but criticises the advice to cut budget deficits. However, important IMF officials dissent. According to the FT, (current, but not then) managing director Christine Lagarde notes that “[a]s the report acknowledges, this assessment is benefiting from hindsight.” And: “Considering the information and growth forecasts available in 2010, I strongly believe that advising economies with rapidly rising debt burdens to move toward measured consolidation was the right call to make.”

Liberal and Conservative Professions and Industries

Andy Kiersz and Hunter Walker report in Businessinsider about a Crowd Pack analysis of US federal campaign contributions.

As far as donors are concerned, the analysis suggests that the media, entertainment and tech industries as well as academics tend to support “liberal” candidates. The same holds true, somewhat less pronounced, for the pharmaceutical industry and lawyers.

In contrast, farmers as well as representatives of the building and construction, mining, oil, gas and coal and tobacco industries mostly support “conservative” candidates. Other industries appear very polarised.

Reserve Requirements

Pablo Federico, Carlos Vegh and Guillermo Vuletin discuss legal reserve requirements in an NBER working paper.

Their data set covers 15 industrial and 37 developing countries over the period 1970–2011. Developing countries typically actively manage legal reserve requirements in the sense of adjusting them at least once over the business cycle. Industrialised countries don’t. None of the latter has changed the requirements after 2004, and many have no requirements at all. Among the active countries, most conduct a counter cyclical reserve requirements policy, often in contrast to a more pro cyclical monetary policy along other dimensions.

Secular Stagnation

Larry Summers explains his secular stagnation hypothesis in Vox: If the full employment real rate of interest (FERIR) is low and so is inflation, full employment may be out of reach. Price rigidities may amplify the effect if they induce expectations of falling prices. In addition, low interest rates tend to undermine financial stability, by fostering an aggressive search for yield and Ponzi schemes. Several factors suggest that the FERIR has been falling. Summers proposes to operate under a higher inflation rate target and to spend more on public investment.

International Bankruptcy Law back on the Agenda?

Elaine Moore writes in the FT that the idea of an international bankruptcy law gains traction, after IMF suggestions in the early 2000s for a “Sovereign Debt Restructuring Mechanism” failed to receive sufficient support. In September, 124 UN General Assembly members supported the proposal to develop a legal framework for restructuring sovereign debt.

This proposal complements the agreement among market participants, international organisations and regulators (against the backdrop of Argentina’s latest default) to change bond clauses with the intention to facilitate renegotiation through binding majority decisions.

The End of Bank Secrecy?

Jeevan Vasagar and Vanessa Houlder report in the FT about the pledge by 51 countries to facilitate the collection and exchange of information on bank accounts and the beneficial ownership of companies and other legal structures. The agreement was drawn up by the OECD and previously endorsed by the G20. Going forward, the countries involved seek a consensus on the treatment of intellectual property income.

Christoph Eisenring in the NZZ and the FAZ provide additional information. Liechtenstein, Luxemburg, Bermuda, the British Virgin Islands and the Cayman Islands signed the accord; Switzerland and Singapore promised to follow soon; Panama and the US didn’t. German finance minister Wolfgang Schäuble declared the end of bank secrecy. While not signing the agreement the US is credited for helping to make it possible, due to the FATCA treaties is has signed with many countries. Those treaties also stipulate an automatic exchange of tax information. However, so far the US has not produced the legal base to provide such information to foreign governments.

Regulation of Fannie Mae and Freddie Mac

The Economist reports about plans to have Fannie Mae and Freddie Mac accept mortgages for intermediation and insurance even if these mortgages only satisfy weaker lending standards than those currently required by the two government sponsored entities. (Fannie Mae and Freddie Mac buy eligible mortgages, repackage and guarantee them and sell them on to investors.) The plans to accept laxer lending standards appear to be motivated by the aim to improve the affordability of home ownership for risky borrowers. The same aim is widely credited to have contributed towards sowing the seeds of the recent financial crisis.

High School (Gymnasium) Graduation Rates in Switzerland

Jörg Krummenacher reports in the NZZ that roughly 20% of a cohort graduate from Switzerland’s most academic type of high school (Gymnasium). In the canton of St. Gallen, only 13% do. Not surprisingly, these St. Gallen high school students do well in standardized PISA tests.

Also, running one additional class of students in high school costs nearly 500 000 Swiss Francs per year. About 80% of St. Gallen pupils entering Gymnasium graduate with the “Matura.”

Sovereign Debt Composition in Advanced Economies

S. M. Ali Abbas, Laura Blattner, Mark De Broeck, Asmaa El-Ganainy and Malin Hu report in Vox about their debt structure database spanning the period 1900–2011 and covering Australia, Austria, Belgium, Canada, France, Germany, Ireland, Italy, the Netherlands, Spain, Sweden, the UK, and the US. Data is disaggregated along the following dimensions: Currency; maturity (of local currency debt); marketability; holders (non-residents, national central bank, domestic commercial banks, rest).

Their main findings are:

  • Advanced economies’ debt typically was denominated in local currency, with the exception of post-WWI France and Italy.
  • Governments issued longer-dated paper in good times.
  • The share of central government debt that was issued in the form of marketable securities declined until after World War II and increased again in the 1970s, to around 80% today.
  • National central banks and domestic commercial banks held about 30% of the debt until 1970. Afterwards, non-resident participation in sovereign debt markets soared.
  • Large increases in debt often were accompanied by a rise of short-term, foreign currency-denominated debt held by the banking system, with the exception of the 1980s and 1990s where more long-term local-currency marketable debt was issued.
  • Evidence for financial repression in combination with inflation after World War II.

They suggest that countries mainly followed two strategies to reduce debt quotas. One, based on fiscal consolidation and moderate inflation, going hand in hand with long maturities. The other, based on high inflation and reliance on debt holdings by captive domestic investors, going hand in hand with shorter maturities.

Link to the data.