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March 25, 2009

Economist's View - 7 new articles

"Has the Gaming of the Public-Private Partnership Begun?"

Yves Smith says things are turning out every bit as badly as she feared:

Has the Gaming of the Public-Private Partnership Begun?, Naked Capitalism: It certainly looks as if Citigroup and Bank of America are using TARP funds, not to lend, which was one of the primary goals of the program, but to scoop up secondary market dreck assets to game the public private investment partnership. And it fleeces the taxpayer a second way: the public has spent enough money on both banks so that in an economic sense, they ought to have been nationalized. Yet for reasons that are largely ideological and cosmetic (the banks' debt would need to be consolidated were they owned 100% by Uncle Sam), they remain private. So not only are they seeking to extract far more than was intended even with the already generous subsidies embodied in this program, but this activity is also speculating with taxpayer money. This sort of thing was predicted here and elsewhere. Welcome to yet more looting. From the New York Post (hat tip reader Hendririx):

As Treasury Secretary Tim Geithner orchestrated a plan to help the nation's largest banks purge themselves of toxic mortgage assets, Citigroup and Bank of America have been aggressively scooping up those same securities in the secondary market, sources told The Post... But the banks' purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults. One Wall Street trader told The Post that what's been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay. Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids. The secondary market represents a key cog in the mortgage market, and serves as a platform where mortgage originators can offload mortgages in bulk that have been converted into bonds. Yields on such securities can be as high as 22 percent, one trader noted. BofA said its purchases of secondary-mortgage paper are part of its plans to breathe life back into the moribund securitization market.... While some observers concur that the buying helps revive a frozen market, others argue the banks are gambling away taxpayer funds instead of lending. Moreover, the MBS market has been so volatile during the economic crisis that a number of investors who already bet a bottom had been reached have gotten whacked as things continued to slide. Around this same time last year some of the same distressed mortgage paper that Citi and BofA are currently snapping up was trading around 50 cents on the dollar, only to plummet to their current levels. One source said that the banks' purchases have helped to keep prices of these troubled securities higher than they would be otherwise. Both banks have launched numerous measures to help stem mortgage foreclosures, and months ago outlined to the government their intention to invest in the secondary market to expand the flow of credit.

The Recession and the Underground Economy

How will the recession impact the underground economy?:

The Other Chicago School, by Elisabeth Eaves, Forbes: You may think the economic meltdown is hitting bankers and Realtors hard, but spare a thought for members of the underground economy--prostitutes, drug dealers and purveyors of stolen goods, to name just a few participants. That's what sociologist Sudhir Venkatesh does, having spent much of the last 15 years studying, and sometimes living within, the underground economies of New York and Chicago.

"The recession is engendering more violence," says Venkatesh, a professor at Columbia University. "There's far greater competition for whatever meager resources there are. The folks down on Wall Street peddling drugs, they're fighting. The sex workers are trying as hard as they can to retain their clients," he says...

Venkatesh is watching black market workers slip into despair along with the rest of the population affected by the economy. Lest legal workers consider this a distant problem, one conclusion of Venkatesh's work is that the underground and mainstream economies are intimately entwined. "The boundaries are fluid, particularly in the global city where the black market has become instrumental--one might even say vital--to the overall economy," he says. In New York City illegal workers serve sex, drugs and takeout to the wealthiest members of society--or at least they did until financial sector layoffs began in 2008.

The underground economy includes a vast array of people providing services that are off the books but otherwise legal. ... And as business contracts, underground workers face certain problems unique to their status. They have no unemployment insurance or other benefits, and, with little protection from law enforcement, they tend to resolve disputes by physical means. ...

Venkatesh is struck by how much the black market resembles the wider society in which it is enmeshed. In the same Parisian banlieues that erupted in riots in 2005, he observed an "almost aristocratic," highly centralized criminal operation. In the ghettos of Chicago, by contrast, he observed underground workers convene an ad hoc court to solve a dispute. His dismisses the "culture of poverty" theory, which suggests that poor blacks in America don't work because they don't value employment. "People in America want to work," he says. They do so ever so industriously, even when they're breaking the law.

Calvo: We Need a Global Lender of Last Resort

Guillermo Calvo argues that we need to establish a global lender of last resort (see also "Central Authority Necessary" and Brad DeLong's "We Need a Hegemon Who Won't Drive Us Crazy..."):

Lender of last resort: Put it on the agenda!, by Guillermo Calvo, Vox EU: The subprime crisis is a massive failure of the shadow banking system that has affected all corners of the capital market and triggered worldwide deleveraging. We are in a severe credit crunch. Savers distrust private-sector dissavers, which gives rise to a fall in aggregate demand and a search for safe assets ("flight to quality").

Therefore, the first priority should be to increase credit to the private sector. The trouble is that the process of deleveraging – partly explained by the virtual disappearance of investment banks – induces banks to lower their risk exposure. This is evident in the failure to produce noticeable credit expansion, despite bank recapitalisation and the US Federal Reserve's absorption of commercial paper. Moreover, the credit crunch depresses asset prices and further discourages credit expansion, launching the economy into a vicious cycle.

Fiscal stimulus packages are second-best. These packages can help restore liquidity in the private sector and consequently increase capacity utilisation and employment. But rapid effects are unlikely, because output is credit-constrained and liquidity accumulation is time-consuming. Thus, solutions should aim directly at restoring credit availability.

Credit availability is not ensured by stricter financial regulation. In fact, it can be counterproductive unless it is accompanied by the establishment of a lender of last resort (LOLR) that radically softens the severity of financial crisis by providing timely credit lines. With that aim in mind, the 20th century saw the creation of national or regional central banks in charge of a subset of the capital market. It has now become apparent that the realm of existing central banks is very limited and the world has no institution that fulfils the necessary global role. The IMF is moving in that direction, but it is still too small and too limited to adequately do so. If, as in the past, IMF lending is tied to elaborate conditionality, it may be also too slow.

What would have happened if the subprime crisis had been met by an effective global central bank that could quickly provide liquidity to the shadow banking system? My conjecture is that the crisis would still have taken place, but its impact, especially on the real economy, would have been much less serious. Granted, effective central banks could give rise to moral hazard, but the latter is best attacked with a good financial regulatory system.

Financial regulation and the lender of last resort

Financial regulation without a lender of last resort has dubious value. In the limit, crises could be avoided by sheer regulations that paralyse financial intermediation and, thus, growth. One concern is that current discussion seems to be obsessed with the design of new regulations that would have prevented the subprime debacle. Typically, politicians look back, fight the last war, and strive to fix superficial defects – seemingly motivated by vendetta rather than deep understanding of the reasons why market failure in a small segment of the economy morphed into the worst global crisis since the 1930s.

Therefore, the first proposal that I would like to make is that the topic of financial regulation should be discussed together with the issue of a global lender of last resort. This is a major issue and I will not attempt to give a full road map here. Generating a full-fledged global LOLR will take time, but there are intermediate steps that are worth exploring. For emerging markets, for example, I proposed the creation of an Emerging Markets Fund (EMF), which would help stabilise their bond prices and insulate them from financial contagion.1 But the lender of last resort issue is so delicate and central that it may require a fundamental overhaul of the foreign-exchange system.

I doubt that unbridled floating exchange rates could be sustained in a new global system in which there is a much greater role for the public sector (in the form of a global LOLR and regulations). Moreover, large devaluations, which are a natural counterpart to flights to quality, could be detrimental to global coordination and cooperation by raising suspicions that they may be prompted by beggar-thy-neighbour motives. To be sure, these suspicions existed prior to current crisis and, as a general rule, do not seem to have had a major impact on international relations or trade in advanced economies.2 However, conditions have changed – finance will not be so readily available to smooth out the effects of large devaluations. Consequently, damage inflicted by large devaluations is likely to be more severe. Policymakers will likely find it harder to ignore them, because their effects will become easily apparent to the general public.

International financial institutions and sudden stops

The second point that I would like to make is that international financial institutions must be quickly endowed with considerably more firepower to help emerging economies through the deleveraging period. Recent experience with systemic financial crises shows that emerging markets can fall prey to sudden stops (of capital inflows) even though solvency is not at stake. In August 1998, for example, the emerging market bond market was hit across the board after the Russian default, despite the fact that Russia represented less than 1% of world output and was not a global financial centre. Like now, the spread of the crisis was attributable to a failure in the international capital market. World depression did not materialise because capital flows were channelled mostly to the US (and arguably sowed the seeds of the dotcoms and subprime crises), but in Latin America, for example, growth stopped for several years. Emerging markets in Asia and Latin America learned the lesson and sought protection in sizable accumulation of international reserves and stronger fiscal and external accounts.3 However, liquidity crises do not distinguish much between saints and sinners. The consequences could be severe and hard to reverse. Sudden stops bring about large and largely unexpected changes in relative prices, causing serious domestic financial turmoil to the point of occasionally obliterating the domestic payments system (e.g., Argentina 2002). These factors are politically destabilising and enhance policy uncertainty, which puts a serious brake on recovery by jeopardising the stability of the rules of the game.

Effectively coping with liquidity crises requires that economies have rapid access to sums that are sufficient to meet short-term financial obligations, e.g., debt amortisations, and avoid a major collapse in aggregate demand. For example, a recent report on Latin America, focusing on debt amortisation and fiscal needs, estimates are that the region may need around $250 billion in the event of a sudden stop.4 For Africa, Eastern Europe, and Latin America, another report focusing on funds required to keep investment at pre-sudden-stop levels – and ignoring factors stressed by the previous report – concludes that this region's needs might exceed $300 billion.5

These sums are large in comparison with recent lending by international financial institutions to those regions. Moreover, prior to the present crisis, loans of rapid disbursal were practically non-existent. Several international financial institutions are actively devising new financial facilities to meet these needs, but a tentative assessment leads me to think that current plans may fall short of generating the necessary funds. Fortunately, several emerging markets in Asia and Latin America have accumulated a sizable stock of international reserves. But spending those reserves could trigger a confidence crisis. Therefore, even under those happy circumstances, it would be useful to have rapid access to international liquidity facilities.

One thing should be clear: liquidity funding need not be disbursed. If the sums or implicit loan guarantees are large enough, the private sector may provide the necessary finance. Insufficient funding may generate the worst of all worlds: the private sector will not participate, countries will be forced to get access to the international financial institutions' facilities and, since funding will be insufficient, a sudden stop crisis will still take place, wreaking havoc on the real economy. Hence, it may be safer to err on the side of "too much" rather than "too little."


In sum, financial regulations have to be accompanied by liquidity facilities mimicking a global lender of last resort. Without them, financial regulations could even become counterproductive. Moreover, in the short run, large liquidity facilities should be put in place to protect emerging market economies from possible sudden stop episodes associated with the current crisis and consequent deleveraging.

Note: I am grateful to Sara Calvo, Rudy Loo-Kung, and Carmen Reinhart for many insightful comments.


1 See Guillermo Calvo, Turmoil in Emerging Capital Markets: Bad Luck or Bad Policy? Cambridge, MA: MIT Press, 2005, Chapter 18.

2 However, empirical studies show that trade is affected by exchange rate volatility in developing economies (see, Calvo and Carmen Reinhart, "Fixing for your Life" in Calvo, op. cit. Chapter 14). Perhaps this is due to the underdevelopment of their capital markets, giving further support to the ensuing conjecture in the text, and another reason why floating exchange rates may be harmful.

3 Unfortunately, Iceland and several Eastern European countries paid little heed to the experiences in Asia and Latin America and accumulated large current account deficits and sizable foreign-exchange denominated debts (including household mortgage debt), presumably thinking that they were different. Also, while many governments in Latin America were successful in reducing their foreign currency debts, the private sector did much to offset this trend during 2001-2007.

4 See Latin American Shadow Financial Regulatory Committee (CLAAF), Statement No. 19, December 2008.

5 See Guillermo Calvo and Rudy Loo-Kung, "Rapid and Large Liquidity Funding for Emerging Markets", Vox EU, 10 December 2008

"Wage Theft"

The Labor Department is not giving workers adequate protection against "unscrupulous employers":

Labor Agency Is Failing Workers, Report Says, by Steven Greenhouse, NY Times: The federal agency charged with enforcing minimum wage, overtime and many other labor laws is failing in that role, leaving millions of workers vulnerable...

In a report scheduled to be released Wednesday, the Government Accountability Office found that ... the Labor Department's Wage and Hour Division, had mishandled 9 of the 10 cases brought by a team of undercover agents posing as aggrieved workers.

In one case, the division failed to investigate a complaint that under-age children in Modesto, Calif., were working during school hours at a meatpacking plant with dangerous machinery...

When an undercover agent posing as a dishwasher called four times to complain about not being paid overtime for 19 weeks, the division's office in Miami failed to return his calls for four months, and when it did, the report said, an official told him it would take 8 to 10 months to begin investigating his case.

"This investigation clearly shows that Labor has left thousands of actual victims of wage theft who sought federal government assistance with nowhere to turn," the report said. "Unfortunately, far too often the result is unscrupulous employers' taking advantage of our country's low-wage workers."

The report pointed to a cavalier attitude by many Wage and Hour Division investigators... During the nine-month investigation, the report said, 5 of the 10 labor complaints that undercover agents filed were not recorded in the Wage and Hour Division's database, and three were not investigated. In two cases, officials recorded that employers had paid back wages, even though they had not.

The accountability office also investigated hundreds of cases that it said the Wage and Hour Division had mishandled. ...

Secretary of Labor Hilda L. Solis said she took the report's findings seriously. ... Ms. Solis said the Wage and Hour Division planned to increase its staff by a third by hiring 250 investigators — 100 of them as part of the federal stimulus package — "to refocus the agency on these enforcement responsibilities"...

Ms. Solis's predecessor, Elaine L. Chao, often defended the Wage and Hour Division, saying it had concentrated on larger, tougher cases, and secured back wages for more than 300,000 workers a year and collected more than twice as much annually as the division had done in the final years of the Clinton administration.

The report concluded that the Wage and Hour Division had mishandled more serious cases 19 percent of the time. ...

I don't have the data to answer it, but the obvious question is whether this was any different before the Bush administration. However, the discussion about shifting enforcement to larger employers under Chao makes it appear that it was different, and Chao's defense makes it seem like taking on big versus small employers is an either-or choice, but it's not. If Republicans had wanted to increase the budget to allow effective enforcement of labor law on behalf of workers at both large and small employers, they could have. It's not like the Democrats would have opposed more effective minimum wage enforcement, or other such proposals. It was a matter of priorities, and this wasn't deemed important enough to draw additional budgetary resources from other purposes (if they thought about it much at all). Hopefully that will change, and the additional investigators that will be hired as well as the change in leadership and direction within the agency is a start to that process.

links for 2009-03-25

"A Song, A Plea"

My daughter (who's about to stimulate the Sacramento economy with the purchase of her first house) passes this along:

It's a Zoo Out There. Or Maybe Not.

[via Discover]

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