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April 1, 2009

Economist's View - 5 new articles

"President Obama Must Squarely Face the Bad Asset Problem"

Lessons from Japan from Keiichiro Kobyashi. The key to recovery, he says, is to get non-performing assets off of bank balance sheets: "The greatest lesson from Japan's experience is not that bank recapitalization should take place quickly, but that market confidence can be restored only when progress is made on the painstaking process of disposing of nonperforming assets":

The G20's Blind Spot: President Obama must squarely face the bad asset problem, by Keiichiro Kobayashi, In proceeding with financial reform in response to the financial crisis, the US has been injecting public funds into banks and struggling companies with little success, sometimes forced to do so repeatedly. It appears that even President Barack Obama, a leader upon whom the expectations of the world await, has been unable to cut the Gordian knot.

The global financial crisis triggered by the collapse of the US housing bubble has been far more serious and fast moving than the crisis following the burst of the Japanese bubble. Yet, just as the two crises differ in their depth and urgency, they also vary in terms of the speed at which they have been dealt with. Indeed, US and European policymakers have responded to the ongoing crisis with much greater alacrity than did Japanese policymakers in the 1990s, or so it initially seemed.

However, as we move beyond the emergency response stage and face the challenge of correcting the fundamental problems that caused the financial crisis, things appear to be quite different. Watching how President Obama has had to continually struggle to work with Congress, I cannot help but realize, all things considered, that politicians in the US, or those in Europe for that matter, are not much different from their Japanese counterparts.

Particularly striking to me has been some of the remarks I have heard from US and British think-tank researchers at recent seminars and conferences. In essence, their remarks can be summarized as follows:

  • Because we USs are extremely optimistic people, we will regain our confidence and begin to increase consumption in one year's time.
  • By stimulating demand through fiscal measures, the prevailing pessimism can be dispelled and confidence in the economy will be restored.

Déjà vu of Japan in the 1990s

It was a bizarre experience. I felt as if I were hearing USs and British recite the same words Japanese politicians, bureaucrats, and bank officials had repeated so many times during the first half of the 1990s. When the finance ministers and central bank governors from the Group of Twenty (G20) major economies met in Horsham, England on March 13-14, they devoted much of their time to discussing fiscal measures. As evidenced by this fact, excessive expectations are being placed on fiscal policies. It is relatively easy to get the people's approval for using fiscal expenditures to finance public works projects, tax breaks, employment measures, and so forth.

I am afraid that today's US and European leaders might be adopting the same mentality as that of the Japanese leaders in the 1990s. That is, it seems to me that they are clinging to wishful thinking by hoping that all of the current global economic problems will solve themselves in due time. As this situation prolongs itself, leaders may buy time with pain-relieving fiscal measures, but by doing so they will continue to ignore the true nature of the problems before them.

Bad debt as the root of the problem

The root problem is an enormous mountain of nonperforming assets. Over the past 10 years the US has undergone two bubbles -- an IT bubble and the housing bubble -- in succession, and has fallen into the habit of borrowing to spend in the process. The aggregate amount of nonperforming assets left in the aftermath of these adjoining bubble periods encompassing the past 10 years is said to be two to three times larger than the amount that Japan had to deal with in the 1990s.

In Japan, two government-backed agencies -- the Resolution and Collection Corp. (RCC) and the Industrial Revitalization Corp. of Japan (IRCJ) -- were established to dispose of soured loans and restructure troubled corporate borrowers such as Daiei Inc. As we learned from Japan's experience, the disposition of nonperforming assets is a painful process that takes enormous time and energy. Given that understanding, it is all the more necessary for the US to develop a well-defined, fundamental policy portfolio to solve the problem of nonperforming assets.

However, the package of plans laid out by Treasury Secretary Timothy Geithner was too abstract and failed to provide a concrete road map. The market was disappointed with the package and the Dow Jones Industrial Average has lost more than 720 points in less than two months since President Obama took office.

How Japan finally turned around in the 1990s crisis

The greatest lesson from Japan's experience is not that bank recapitalization should take place quickly, but that market confidence can be restored only when progress is made on the painstaking process of disposing of nonperforming assets. In retrospect, the recapitalization of banks in 1998 and 1999 delivered only a temporary respite and did not guide the Japanese economy onto a true path of recovery.

Only after Resona Bank had been temporarily placed under government control, the IRCJ had been established, and Japanese banks had embarked on an all-out effort to dispose of bad loans, did stock prices finally pick up and people come to embrace the recovery. Up until then, whatever measures had been taken by the government -- whether bank recapitalization or pork-barrel fiscal spending -- did nothing but provide temporary pain relief.

How to address today's problem

Continuing to give "adrenaline shots" of fiscal expenditures would not cure a patient suffering from the "cancerous" effects of nonperforming assets unless the cancer tumour was removed by surgery. However, surgery this time around -- the removal of nonperforming assets from US and European banks -- is going to be far more difficult than the previous procedure that relieved Japanese banks of their bad loans.

First, the nonperforming assets from the latest crisis have been chopped up and embedded in various forms of different types of securities that have been spread among investors and financial institutions across the world. The disposition of nonperforming assets involves identifying the holders of these securities, determining the amount of losses the creditors have incurred on such securities, and then persuading them to take their share of the losses. Altogether, this process would require an enormous amount of time and effort. Negotiations on burden-sharing are, by definition, a troublesome task that no one wants to deal with. That task is even more challenging this time around because the disposition of nonperforming assets will have to proceed multilaterally with affected parties scattered around the world.

However, due to strong public opposition and/or the intertwining of interests, most countries are far from being ready to coordinate and work together to clean up nonperforming assets. At the present time the US and European countries are most likely in a state of paralysis in terms of addressing the problem of nonperforming assets. Just 10 years ago in 1999, I had an opportunity to discuss with a leading financial economist what policy measures should be implemented to revive the Japanese economy. After providing clear analysis and pointing to the necessity of disposing of a massive amount of bad loans as a prerequisite to achieving an economic recovery, he self-mockingly added, "but the fact is that all of us are utterly stricken and standing transfixed by the sheer scale of the problem before us, isn't it?"

Wishful thinking on fiscal stimulus

This might be the state in which the Americans and British find themselves today. A counter-reaction to this state of paralysis might be manifesting itself in the form of excessively wishful thinking about the effects of fiscal policies. Many decision makers want to force themselves to believe that fiscal measures will cure the problem because there is nothing else they can do at the moment. However, as we learned in Japan in the 1990s, people in the US and Britain will soon realize that fiscal measures alone cannot provide an ultimate cure.

What happens next? One probable future scenario would have the US and global economies temporarily regaining strength over the next two to three years with the support of fiscal measures, but the problem of nonperforming assets, the root cause of the ongoing economic turmoil, would remain unsolved because of various political difficulties such as strong public opposition to bailing out banks. Consequently, once the painkilling effect of fiscal measures wears off, the US and global economies would once again plunge into another serious crisis.

Only after going through this ordeal and realizing that fiscal measures alone cannot solve the problem would people recognize the need for ultimately disposing of nonperforming assets. And only then could a global policy scheme for addressing the core problem of financial instability be formulated. But until this happens, the US government will most likely continue to run a fiscal deficit, further snow-balling its already huge federal debt.

For Japan, this crisis is not akin to a fire on the other side of the river. As the US economy continues to stagnate, the Japanese economy will be the hardest hit because its exports will suffer directly from the sluggish demand in the world's largest market. Thus, Japan has no choice but to keep on priming the fiscal pump to prop up its economy. Finance Minister Kaoru Yosano promised a ¥3 trillion fiscal stimulus package at the Horsham G20 meeting, but Japan will still need to take further fiscal steps and act in tandem with the US in the coming months.


So long as people hold onto the expectation that recovery could be brought about by fiscal measures, no national consensus can be built to proceed with the painful disposition of nonperforming assets. It is necessary to learn by firsthand experience that fiscal measures are only makeshift. In this context, the enormous fiscal deficit that will be built up in the US in the coming months may be the political cost for consensus building, which would be a replay of what Japan went through in the 1990s.

Up until several years ago, the US and European countries had repeatedly criticized Japan's policy responses for being too slow. But it might be the case that US and European policy responses are just as slow as those of Japan when it comes to tackling the daunting task of solving nonperforming asset problems. By studying Japan's experience, foreign policymakers have an excellent example from which they can learn what not to do. Yet, the recent developments show just how difficult it is to learn from the mistakes of others. We, as human beings, are by nature probably unable to take to heart anything having negative implications unless we learn its lesson the hard way through firsthand experience.

Stiglitz: Obama's Ersatz Capitalism

Joseph Stiglitz is not a fan of the Geithner bank bailout plan:

Obama's Ersatz Capitalism, by Joseph E. Stiglitz, Commentary, NY Times: The Obama administration's $500 billion or more proposal to deal with America's ailing banks ... is based on letting the market determine the prices of the banks' "toxic assets"... The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. ... This is exactly the same as being given an option. ...

Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership! ...

But Americans are likely to lose even more ... because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets, and especially the assets ... the market ... is willing to pay too much for...But the market is likely to recognize this, which will drive down the price... Only the government's picking up enough of the losses overcomes this "adverse selection" effect. ...

The main problem is not a lack of liquidity. ... The real issue is that the banks made bad loans... They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.

Some Americans are afraid that the government might temporarily "nationalize" the banks... What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a "partnership" in which one partner robs the other. ...

So what is the appeal of a proposal like this? Perhaps it's the kind of Rube Goldberg device that Wall Street loves — clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

But we are already suffering from a crisis of confidence. When the high costs of the administration's plan become apparent, confidence will be eroded further. At that point the task of recreating a vibrant financial sector, and resuscitating the economy, will be even harder.

Asia and the "Bond Bubble"

Yu Qiao says Asian countries are worried about their large investment in dollar denominated US assets and would like one of those one-sided, heads we win, tails the taxpayers loses deals that everyone else seems to be getting:

Asia is the victim if the bond bubble bursts, by Yu Qiao, Commentary, Financial Times: ...Most of Mr Obama's stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America's over-consumption problem and delay sustainable recovery. On top of this, the unprecedented fiscal stimulus, with the Federal Reserve's move to inject money into credit markets, contains self-destructive seeds. ... In the long term, America may seek to resolve its economic mess by devaluing the dollar at best and a default at worst. ... It is the foreign holders of US obligations denominated in dollars that would end up paying.

Analysts have warned of the dangers of the US Treasury bond bubble that developed in late 2008. ... If this bubble burst, east Asians would be victims..., the consequences would devastate Asians' hard-earned wealth and terminate economic globalisation.

No other international monetary system offers a viable alternative. However, we can make the main reserve currency power more accountable by creating an instrument to help manage the global crisis.

The basic idea is to turn Asian savings, China's in particular, into real business investments rather than let them be used to support US over-consumption... [E]quity claims on sound corporations and infrastructure projects are at less risk from a currency default. But Asians do not want to bear the risk of this investment because of market turbulence and a lack of knowledge of cultural, legal and regulatory issues in US businesses. However if a guarantee scheme were created, Asian savers could be willing to invest directly in capital-hungry US industries.

First, Asian countries could negotiate with the US government to create a crisis relief facility. The CRF would be used alongside US federal efforts to stabilise the banking system and to invest in capital-intensive infrastructure projects such as a high-speed railway from Boston to Washington DC.

Second, Asians could pool a proportion of their holdings of Treasury bonds under the CRF umbrella to convert sovereign debt into equity investment. Any CRF funds, earmarked for industrial commitment, would still be owned and managed by their respective countries. In return, Asians would hold minor equity shares that would, like preferred stock, be convertible .

Third, the US government would act as the guarantor, providing a sovereign guarantee scheme to assure the investment principal of the CRF against possible default of targeted companies or projects. Fourth, the Fed would set up a special account with the US government to supply liquidity that the CRF requires to swap sovereign debt into industrial investment in the US.

The CRF would lessen Asians' concern about implicit default of sovereign debts caused by a collapsing dollar. It would cost little and help the US by channelling funds to business investment. Conventional Keynesian policies – fiscal and monetary expansion on a national basis – cannot solve the problem but will make it worse.

If China and other Asian countries were to fix their under-consumption problem, that would help too (though not right now, if the cheap foreign loans dry up that will make recovery harder).

links for 2009-04-01

"Obama Budget Reduces Deficit"

The Center on Budget and Policy Priorities says that, contrary to what you may have heard, the Obama budget "would reduce federal deficits by about $900 billion over the next ten years compared to current budget policies." Note also that, relative to their "realistic baseline," the deficit is larger in the immediate short-run than the baseline projection (but by enough?), and smaller in the longer run (any truly long-run solution to the budget problem will require us to reform health care and reduce escalating costs):

Obama Budget Reduces Deficit by $900 Billion Compared to Current Budget Policies, by Kathy Ruffing and Paul N. Van de Water, CBPP: Contrary to some claims, President Obama's 2010 budget would reduce federal deficits by about $900 billion over the next ten years compared to current budget policies. The $900 billion is the difference between deficits over the next decade under the President's budget, as estimated by the Congressional Budget Office (CBO), and projected deficits under a realistic assessment of current budget policies. (See figure below.)

Some critics charge that Obama's budget is fiscally irresponsible, and they cite CBO's estimate that, under it, deficits would total $9.3 trillion over the next decade. They fail to note, however, that these future deficits result from the existing budget policies that Obama inherited — not those that he is proposing. Ironically, some of these same critics supported the large tax cuts and spending increases of recent years that helped convert the surpluses of the late 1990s into the record deficits that we face today and in the coming decades.

In fact, deficits would be $900 billion higher over the next decade under current policies than in Obama's budget. That's because, in the budget plan that he released in late February, the President includes a package of spending and tax proposals that reduce future deficits by that amount.

Discussions of the budget outlook typically begin with the budget "baseline"... In building the baseline, CBO follows rules that ... generally assume that current laws affecting taxes and mandatory spending will continue without change.

Sometimes, however, current law diverges from current budget policies. This year, the official budget baseline incorporates several especially unrealistic assumptions. In particular, the latest baseline assumes that Congress will allow the 2001 and 2003 tax cuts, relief from the Alternative Minimum Tax, and other temporary tax provisions all to expire. It also assumes that the reductions in physician fees called for under Medicare's sustainable growth rate formula — including a 20 percent reduction in 2010 — will actually take effect, even though Congress has stepped in to prevent such reductions since 2003. Finally, the baseline extrapolates enacted defense appropriations for 2009, which represent only a portion of the amount needed for operations in Iraq and Afghanistan this year and in coming years. ...

Budget experts have been saying for a number of years that the official baseline departs sharply from reality. ... In February 2009, CBO issued alternative budget scenarios that offered a more accurate representation of current budgetary policy. [2] We rely here on elements of those alternative budget projections and have updated them to be consistent with CBO's new March 2009 baseline...

In our projection of the deficit under current budget policies, we adjust the official CBO baseline... These adjustments are detailed in the appendix table. Cumulatively, they point to deficits of $10.2 trillion over the next 10 years... CBO estimates that the cumulative deficit from 2010 to 2019 under the President's proposals would total $9.3 trillion. Compared to our realistic baseline, the President's proposals would reduce projected deficits by about $900 billion over the 2010-2019 period. [4] The deficit would be higher in 2009 and 2010, however, because the budget sets aside an additional $250 billion for stabilization of financial markets. ...

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