Bad News

A picture is worth a thousand words, and one of the most informative pictures is the Kindleberger Spiral, which shows the collapse of world trade that made the Depression Great. The picture first appeared in his great book, The World in Depression.

The reason for posting this now is an article by Floyd Norris about the decline of world trade in the NYTimes. The big fear is that countries will respond to declines in their exports with protectionist policies. This is how the spiral starts. We don't want to see where it ends.

Grading on a Curve

I noted before that this is an amazing crisis. While we may have caused it, the rest of the world feels it much more. Floyd Norris notes, that if we have to grade on a curve, the US probably gets an A for its economic performance in the last year. For example,

In the fourth quarter of last year, the American economy shrank at a 3.8 percent annual rate, the worst such performance in a quarter-century. They are envious in Japan, where this week the comparable figure came in at negative 12.7 percent — three times as bad.

Industrial production in the United States is falling at the fastest rate in three decades. But the 10 percent year-over-year plunge reported this week for January looks good in comparison to the declines in countries like Germany, off almost 13 percent in its most recently reported month, and South Korea, down about 21 percent.

Another way to look at it is to ask what would be the current value of $100 invested in the stock market on Dec 31, 2007 in various countries? Again, we do pretty well. While it would only be worth $53 today, consider that:

Among major markets, only Japan, at $59, has done better. In Britain, France, Spain and Germany, the figure would be around $45. In Italy, it would be $37. About a quarter of the money would still be there in countries like Ireland, Greece and Poland.

Remember the BRIC countries, where growth possibilities seemed limitless not long ago? The stars there are Brazil and China, where about $46 or $47 remains. In India, the figure is $35, and in Russia it is $23. At least they have all done a lot better than Iceland, where you would have just $3 left of your hypothetical $100.

In international finance we often talk of sudden stops. When capital inflows cease because of some shock to confidence (or in this case an increase in risk aversion in the financial capital) then it is like hitting a lamppost in your speeding car. Seems like this unfortunate metaphor is really hitting in many places now. I suppose that makes us the elderly driver driving so slowly that we induced other drivers to make the risky pass.

Eastern Europe in Trouble

The crisis is clearly hitting Eastern Europe hard. See here and here. Countries that had been growing fast, based on cheap foreign borrowing, are now hurting as the capital flow is reversing. Moreover, these countries must now repay their debts denominated in currencies that have appreciated relative to those in Eastern Europe. Fragile banking systems are also threatened.

This is the background to the call yesterday:

European leaders called for doubling the International Monetary Fund's war chest to $500 billion for bailing out financially stricken nations, amid new signs that Europe's former Communist east is sliding into a full-blown crisis.

This is all in the wake of already approved programs for Hungary, Ukraine, Iceland, Belarus, and Latvia worth more than $39 billion, and a request from Serbia will be considered soon.

Housing Plan

I need to comment about the Obama housing rescue plan, but I am not ready yet. The big problem is that I get too outraged when I think of bailing people out who took mortgages that were too large for their incomes. This prevents me from thinking straight enough to complete a post.

Fortunately, Willem Buiter has a nice post on this topic. He thinks housing in the US is the biggest racket since Al Capone. Tyler Cowen also has sensible comments. I especially agree that the problem is to get prices to fall so that markets clear, not to artificially support them at a level where they cannot be maintained. But unlike him, I cannot shake the moral outrage.

Worse then Japan

The Economist has an article that suggests that our financial crisis may be worse than Japan's and that we should not dismiss it lightly:

Japan’s outcome—a decade in which growth averaged 1% a year and gross government debt rose by 80 percentage points of GDP—was not one to be proud of. But given the magnitude of today’s mess, it may soon seem not that bad after all.

There are several reasons for thinking that our problems may be worse. Our housing bubble was larger, our shadow banking system has collapsed -- Japan did not have one, de-leveraging is taking place on a massive scale, and it is hard to see where demand is going to come from in the rest of the world to pull us out of this. Japan suffered its crisis with high savings rates, we start with low savings. Hence, as households in America try to restore their balance sheets where will demand come from?

Executive Compensation

Lucian Bebchuk, who is no fan of excessive executive compensation, is nonetheless very critical of the restrictions placed in the stimulus bill. He points out that the bill weakens the link between pay and performance. Even more importantly, it provides incentives for executives to take excessive risks since it restricts their incentive pay to restricted stock.

Irving Fisher

The Economist has a nice article on Irving Fisher, whose relevance is increasing because of his famous article on Debt Deflation.

Crisis Deepens

Two signs that the crisis is deepening worldwide. From Russia we see that industrial production fell in January at an annual rate of 16%. Russia is of course suffering from the collapse of the world economy, oil prices declining, and the outflow of capital from its thin financial system. Moreover, since its prosperity had bubble-like features, it is not surprising that its collapse looks so severe.

Meanwhile, Japan's GDP fell by 12.7% in the last quarter, the worst fall since the first oil shock in 1974. See the pictures here. Japan is suffering from the collapse in demand for its exports, and the unwinding of the carry trade which had kept its currency undervalued. Edward Hugh argues that the aging of Japan's population makes them especially vulnerable to declines in export demand since consumption growth is restrained.

And I was already depressed by the "Buy America" features of the stimulus bill. We live in an interdependent world, and such policies are only going to make things worse.

A Different Kind of Recession

Axel Leijonhufvud has a very interesting article in VoxEu. The key point is that this is not a normal recession. It is one caused by the private sector trying to de-leverage. Without fixing that hole the fiscal stimulus will not work:

Fiscal stimulus will not have much effect as long as the financial system is deleveraging. Even if that problem were to be more or less solved, the government deficit would have to offset both the decline in industry investment and the rise in household saving – a gap that is rising as the recession deepens. Here, too, the public is sceptical and prone to conclude that a program that only slows or stops the decline but fails to “jump start” the economy must have been a waste of tax payers’ money. The most effective composition of such a program is also a problem.

Solutions are not simple, but the most important lesson is that if we do not understand the causes of the recession -- if we have no model for why we have unemployment now -- we cannot suggest good policies to remedy it.

Bank Bailout

Two articles in today's NYTimes on the bank bailout. The first points out that the costs may be much larger than people think.

A sober assessment of the growing mountain of losses from bad bets, measured in today’s marketplace, would overwhelm the value of the banks’ assets, they say. The banks, in their view, are insolvent.

The second article looks at the parallels with Japan's lost decade:

The Japanese have been here before. They endured a “lost decade” of economic stagnation in the 1990s as their banks labored under crippling debt, and successive governments wasted trillions of yen on half-measures.

“I thought America had studied Japan’s failures,” said Hirofumi Gomi, a top official at Japan’s Financial Services Agency during the crisis. “Why is it making the same mistakes?”

Two points come to mind immediately. First, on the size of the losses. These come from marking to market "toxic' assets. But as I noted in previous posts these are due to information and coordination problems. The market values are low because they value an arbitrary collection of mortgages not the whole complex of them. So the amount needed to capitalize the banking system is larger with a plan that is not comprehensive. On the magnitude of the costs and the argument for nationalizing the banks, see this article by Roubini and Richardson in the Washington Post.

Second, delay just magnifies the costs, but here politics is vital. Half measures to avoid the painful costs only multiply them later. But given how difficult the stimulus plan was to pass, is it credible that Treasury will now undertake a comprehensive plan? Of course, my plan is comprehensive, and ultimately not that costly, but where is the groundswell of support?

Whose Interests Are They?

Today's NYTimes has an editorial about Mr. Obama and Russia. The article is quite remarkable. Their suggestion for starting a new relationship with Russia is for America to focus on arms control and Iran. They write:

Arms control may be the most promising area for early progress. The 2002 Moscow treaty, Mr. Bush’s one and only agreement, allows each country to deploy between 1,700 and 2,200 long-range nuclear weapons. They could easily go to 1,000 weapons each.

One might wonder why Russia would be interested in this. After all, decommissioning nuclear weapons is more expensive than maintaining them. Perhaps they want to eliminate the one factor that makes Russia relevant in international relations?

The highlight of the article, however, is this gem:

The administration also will have to test whether Moscow will do more to help end Iran’s nuclear program. That, too, is in Russia’s clear strategic interest, even though the Kremlin has yet to see it.

The problem with the whole article is that it wants to create a new Russia by focusing on issues that are of concern to us but not to Russia (of course, we know Russia's interests better than they do). We want Russia to cooperate on things we care about and we want them to endure (in silence) our complaints about their behavior in other areas. Hard to build a relationship that way.

As attentive reader Clifford Gaddy notes:

Well, I hope Putin's checks his NYT daily, so he can see what Russia's strategic interests really are.

How Toxic Update

In my initial post on solving the toxic assets problem I focused on the foreclosure rate to estimate losses. But that may not be quite correct. The key statistic is the foreclosure rate on mortgages in the population of mortgages financed by CDO's. This rate may be higher, I need to check on that. The issue is what are the maximum losses in all the mortgages that underlay CDO's.

How Toxic are Toxic Assets?

Brad Setzer has a good post on the Treasury's new plan to deal with toxic assets. Clearly dealing with the credit crisis is the key factor in getting any recovery going. And it is the most difficult. Primarily, I think, for political economy reasons. The problem is who should bear the brunt of the losses. But there is also a coordination problem involved.

To see this, first note that so-called "toxic assets" are complex collections of mortgages. These CDO's are derivatives whose value depends on the payoffs on the underlying assets. So the losses on the whole universe of these assets cannot be bigger than the losses on the underlying assets. The problem is that nobody knows what individual collections -- CDO's are worth. Hence, they trade for little value in the market, and banks are reluctant to sell them at low prices; choosing instead to keep them on their balance sheets. And then they are frozen from lending and instead hoard bailout funds until the value of the CDO's pay off (they hope).

Now let us make a back of the envelope calculation. A really high foreclosure rate is 8%, so let us take 10%. If foreclosure takes place not all value is lost for the mortgage holder, but let us suppose it is. Then if one held the entire portfolio of mortgage backed securities the maximum losses on the total portfolio would be 10%. The big problem today is that banks hold CDO's of uncertain value -- nobody wants to pay a lot for a tranche that could have lots of bad mortgages. But other tranches must have good mortgages. Even if we consider CDO-squared's -- collections of collections -- the underlying risks ought to be no more than 10% figured conservatively.

Suppose then that the government took all CDO's and held them to maturity. It would, at worst, earn 90 cents on the dollar. So if it exchanged for these assets a security that pays 90 cents, and gave each bank a pro rata share (this would have to be based on nominal value not market value) then banks would receive 90 cents for sure instead of some uncertain value. Wouldn't this plan break even for the government? And wouldn't the banks -- as a whole -- be better off? Couldn't lending re-start? If the answer is yes, then the fundamental problem is information and coordination. It is a problem of who to allocate the losses to.

What am I missing?

Dedicated reader Vijay Krishna reminds me that this solution is related to an old puzzler on Car Talk:

The problem is that you have to take two identically looking pills each day. You are isolated from your doctor for 30 days and cannot get resupplied. If you don't take them both you die (you could change the proportions and volumes). But you spill the pills on the floor. What are you to do?

The solution offered by Click and Clack is to take all the pills from the floor, crush them up, mix them up in water, and divide the solution by the number of days. Then each day take a share of the solution equal to one divided by the number of days left.

The similarity is clear. Taken in total we have a collection of pills or mortgages that is not all that harmful. But arbitrary portions of the collections can be extremely hazardous to your health.

Fiscal Stimulus, Again

Jim Hamilton's recent post on the stimulus hits the nail right on the head. The point is not that fiscal stimulus cannot work, as some argue. If you could change some textbook G in a continuous fashion like a TV dial it could work in a time of massive unemployment. But that is not the world we live in, so real programs must fill in the spending. But Hamilton's key point is that we need to think of the type of crisis we are in. If the cause of the recession is the piercing of a housing bubble and a credit crisis it is not clear that public works is the answer. We need to get the financial system working properly again.

I also agree with Jim that helping States with budget shortfalls to prevent further layoffs is a good idea.