Is the world economy on its way out of the crisis? Has the world been learning the right lessons? The answer to both questions is: up to a point. We have done some of the right things and learnt some of the right lessons. But we have neither done enough nor learnt enough. Recovery will be slow and painful, with substantial danger of relapses.

Start, however, with the good news. The financial crisis, narrowly defined, is over: stock markets have rallied; liquidity is returning to markets; banks have been able to raise equity; and the extreme risk spreads in financial markets of last year have disappeared. When addressed powerfully, panics end. In this case, the commitment of the authorities to the rescue of a failing financial system was unprecedented. It has had the desired results.

The worst of the economic crisis is also passing. As the Organisation for Economic Co-operation and Development noted in its latest Economic Outlook, “for the first time since June 2007, the projections … have been revised up for the OECD area as a whole compared with the previous issue”. Similarly, the International Monetary Fund states in its latest World Economic Outlook update that “economic growth during 2009-10 is now projected to be about half a percentage point higher than forecast by the IMF in April, reaching 2.5 per cent in 2010”.

The remainder of the article can be read here. Debate from our panel of economists appears below.

Martin’s article “The cautious approach to fixing banks will not work” stimulated me to raise a fundamental issue that is preoccupying me as the crisis unfolds and to which I don’t have an answer.

The standard orthodox prescription suggested by Martin, Krugman and others is to contain the systemic banking sector crisis with a set of comprehensive policy measures that include a rigorous assessment of major banks’ balance sheets, removal of non-performing loans from banks’ balance sheets, and banks recapitalisation. Virtually all the analysts point out the spectre of the Japanese lost decade, and applicable lessons for the recent US crisis. Recently two papers address the Japanese crisis: Lessons from Japan’s Banking Crisis, 1991-2005 by Mariko Fujii Research Center for Advanced Science and Technology University of Tokyo and Masahiro Kawai, Asian Development Bank Institute, and Hoshi Takeo and Anil K Kashyap. 2008, “Will the US Bank Recapitalization Succeed? Lessons from Japan”, NBER Working Paper 14401, Cambridge, Massachusetts: National Bureau of Economic Research.

The Fujii-Kawai paper concludes with the following: “Acknowledging the extent and depth of the bank balance sheet problem - potential loan losses - is the first step toward resolving a banking crisis. In this regard, once the government determines a rough estimate of the size of the crisis, prompt action to recapitalize the banks that are viable, but are under-capitalized is an effective measure to restore market confidence and stabilize the banking system. Then removal of impaired assets from bank balance sheets is the next step.”

In reading the Fujii-Kawai paper I find some of the data striking. First, a chart that points out that the urban land price dropped from an index of 400 in the 1990s to 100 now. Similarly, the concentration of bank lending in real estate was very high. In “Japan’s lessons for a world of balance-sheet deflation”  (February 17), Martin cites an analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute; The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (Wiley, 2008) and discusses the deleveraging process of balance-sheet financed by debt. Following the unfolding of the US bubble in real estate, in makes me far more sympathetic and understanding of the Japanese authorities’ dilemma in the early 90s. Intervention - assessment of major banks’ balance sheets, removal of NPLs from bank balance sheets, and bank recapitalization - at any point in the early 90s was equivalent trying to catch a “falling knife”. Not sure that no amount of intervention can stop the deleveraging process. My take from this data is fairly straightforward - the process of deleveraging and accrual of bad debt is dynamic and creates a vicious cycle, and no amount of government intervention would have or should have tried to stop the market forces and deleveraging process.

It leads to the following question: what does Japan’s “lost decade” teaches us?  While the standard prescription to intervene promptly is very nice to present, maybe we need to turn things upside down, and look at them in a different light. In a recent talk on the “Challenges to the Global Economy” at MIT (March, 2009) Martin Feldstein gave a very nice lecture outlining similar dynamics re the housing prices in the US. In America, Zillow Real Estate estimates that the downturn in home prices has left about 20% of homeowners owing more on a mortgage than their homes are worth. We are in a vicious cycle, with more houses getting foreclosed and coming to the market, leading to further price declines. A similar deleveraging process has to take place in commercial real estates, such as retail. Deutsche Bank has recently released sobering estimates regarding the prospective losses in commercial real estate. Equally, in light of the lost real estate and equities wealth, the household sector has to deleverage. Defaults in consumer credit are likely. 

The evidence leads me to my counterfactual question. Can the deleveraging process be stopped through fiscal interventions? Admittedly, it will be interesting to quantify the losses and calculate the costs of intervention to assess if intervention is feasible by looking at the aggregate numbers before answering the question. I have not analysed the aggregate numbers for the US, UK or Spain.  But I doubt intervention is feasible. So maybe we need to drop the orthodox prescription to contain this systemic banking sector crisis, such as:  

• rigorous examinations of the credit quality of the major banks’ balance sheets, such as the US government’s stress tests, are a pointless exercise when credit quality continues to deteriorate;
• removal of non performing loans from bank balance sheets is pointless because it addresses the present stock of non performing loans and not the flow;
• and bank recapitalisation is ineffective when the flow of non performing loans will lead to future losses.  

My sense is that in the US, even if intervention on the order of magnitude required was feasible (and I doubt it), the political will, financial resources, and economic wisdom to intervene to offset the assets and wealth losses are simply not there. So as painful as it is, maybe the leveraging process has to proceed and the government should stand by ensuring only the payment system, and facilitate the deleveraging process.

I realise those conclusions are unconventional. Comments are welcome.

In their classic routine, Carl Reiner asks Mel Brooks, the 2000 Year Old Man, to explain how he has managed to live for so long. Brooks replies that he avoids fruits, vegetables, meats, grains - each of which causes some comic side effect. All that’s left for him is “cool mountain water.” “Just that,” the old man says, “and a stuffed cabbage.” Reiner asks whether stuffed cabbage is allowed on his diet. The answer, of course, is “What, you think for a little mountain water I’m gonna keep myself alive?”

Financial risk-taking has come to a similar juncture. Politicians and regulators agree that risk doesn’t belong in banks because it might require another taxpayer bailout. It doesn’t belong in hedge funds either - they are murky and generally wicked. Be sure not to imperil insurance companies or government agencies. And keep risk far away from retail investors, who need protection most of all. Oh yeah, we want risk-taking somewhere so we can have a dynamic economy. It’s our financial stuffed cabbage.

We could simply accept less risk-taking and live with the consequences. Angela Merkel argued last week for tougher rules for financial institutions, acknowledging that they would curtail growth during the boom times but arguing that lower growth is acceptable in exchange for a world with fewer bubbles.

Merkel’s solution would be a sad and unnecessary outcome. We can have simpler banks operating with higher capital ratios and less leverage without sacrificing dynamism. Society has tools at its fingertips that can do the job.

One of them, securitisation, has a battered reputation due to its role in the US mortgage crisis and excesses of structured finance CDOs, and regulators are keen to reign it in. But without any radical regulatory changes or any new institutions, securitisation could help build a resilient financial system in which banks function like utilities: banks can take deposits, originate and service loans to their clients, then ship the risk off to end investors. It is these investors, such as hedge funds or sovereign wealth funds - whose profits and losses will be a concern to themselves and not the public - who bear the risk.

Let’s consider an example: Europe’s small and medium size enterprises (SMEs). These family businesses obtain loans or working capital facilities via their relationship banks. They are too small to tap the capital markets directly. They do not want to issue shares that will dilute the family’s control or complicate corporate governance.

For more than a decade, SME securitisation has helped European banks simplify their balance sheets and free up credit lines to make loans to these companies. Currently, 70 publicly rated European SME transactions are outstanding. They shift the risk of 400,000 SME loans in Germany, Spain, Belgium, the Netherlands, Portugal and the UK Taken together, they save the banks about €15bn in Tier 1 capital - about half of one Deutsche Bank. The figures do not even include the private, bilateral market which may be as large again as the public.

During the financial crisis, some investors in SME securitisations lost money, particularly those who bought deals from Spain. But that is how it is supposed to work. Spanish banks received compensation to offset the losses in their lending books.

European SME securitisations are largely synthetic, meaning the credit risk is transferred to a special purpose vehicle through a credit default swap. (This is a clear example of vilified devices serving purposes of good.) The loans remain on the banks’ books, so securitisation will not disrupt longstanding relationships between the banks and their clients.

To preserve and expand the benefits of securitisation, regulators need to abide by four dos and don’ts:

1) Do prohibit banks and their affiliates from buying the securitisations of other banks. This opens up endless possibilities to game the capital rules. For the past nine months, banks and proprietary trading desks of investment banks have banded together to issue callable structures to one another. These deals are virtually risk free for both sides, yet they succeed in reducing the issuers’ risk weighted assets. Securitisations belong with end-investors.

2) Do give banks credit for assets that have been securitised, especially when imposing limits on gross leverage, even if those assets remain in the banks’ financial statements.

3) Don’t force issuers to retain a portion of the assets they securitise. Such a primitive attempt to achieve alignment of interests won’t work, because banks are not one person, and it is a mistake to anthropomorphise them. Just because one part of a bank owns a sliver of risk will not affect how a lending officer in another part services the loan, or what diligence a workout officer will apply when seeking to maximise recoveries.

4) Don’t implement rules to increase transparency. The marketplace will demand and get the transparency it requires. Banks have every incentive to balance the information they release with the extra comfort it gives investors. Regulation will result in less efficient structures which will translate into less securitisation and ultimately less lending.

We must not give up on the prospect of safe banks and a financial system that will foster a dynamic economy. With only a little help from regulators, banks with higher capital requirements will naturally choose to securitize. European SME securitisation, alone, could grow to five times it current size. Investors - not taxpayers - will be rewarded (or not) for the risks they knowingly accept.

The author is chief executive officer of investment management firm Christofferson, Robb & Co. and professor at Columbia’s School of International and Public Affairs

Perhaps one of the economic phenomena most akin to witch-hunting is the diagnostic and policy response that develops during the recovery phase of a financial crisis.  Understandably, pressured politicians and policymakers rush to find culprits and sources of instant gratification. All too often they find a ready supply of these in preconceptions and superficial analyses of correlations.  This time around the scapegoats are global imbalances and leverage.

Global imbalances are the victim of preconceptions: Many economists and commentators argued before the crisis that large global imbalances would lead to the demise of the U.S. economy once capital flows decided to run en masse, as often happens with the sudden stops that afflict emerging market economies. The crisis indeed came, but rather than destabilizing the US economy, capital flows helped to stabilise it, as flight-to-quality capital sought rather than ran away from US assets. (There was a reallocation from private to public assets which was indeed very destructive, but it had little to do with the distinction between foreign and domestic assets highlighted by the sudden stop camp.)

The fact that the actual mechanism behind the crisis had nothing to do with that which was used to explain the forecast of doom has long being forgotten, false idols have been erected, and new gurus roam the land. Along the way, global imbalances have been indicted for witchcraft, and ever more exotic rebalancing and currency proposals make it to the front pages of newspapers around the world.

Leverage is the victim of superficial analyses of correlations: In my view one of the main factors behind the severity of the financial crisis was the excessive concentration of aggregate risk in highly-leveraged financial institutions. Note that the emphasis is on the concentration of aggregate risk rather than on the much-hyped leverage. The problem in the current crisis was not leverage per se, but the fact that banks had held on to AAA tranches of structured asset-backed securities which were more exposed to aggregate surprise shocks than their rating would, when misinterpreted, suggest.

Thus, when systemic confusion emerged, these complex financial instruments quickly soured, compromised the balance sheet of their leveraged holders, and triggered asset fire sales which ravaged balance sheets across financial institutions. The result was a vicious feedback loop between assets exposed to aggregate conditions and leveraged balance sheets.

The distinction emphasized in the previous paragraph may seem subtle, but it turns out to have a first order implication for economic policy design. The optimal policy response to this problem is not to increase capital requirements (or to deleverage), as the current fashion has it, but to remove the aggregate risk from systemically important leveraged financial institutions’ balance sheets. This should be done through prepaid and often mandatory macro-insurance type arrangements, which can accommodate valid too-big or too-complex to fail concerns, but without crippling the financial industry with the burden of brute-force capital requirements.

In summary, it is not global imbalances or leverage that need to be reined in. Instead, the key imbalance was in the massive demand for AAA-instruments from all parts of the world (including US money market funds and other domestic institutional investors) which the US financial sector was unable to produce regardless of how much aggregation and tranching contortions it used to fit the task. More precisely, the financial sector can produce it, but not during severe crises, and it is this specific gap that needs to be fixed with pre-arranged public support and paid for up front.

What will the world economy – indeed, the world – look like after the financial crisis is over? Will this prove to be a mere blip or something more fundamental? Much of the answer will be provided by the performance of the two Asian giants, China and India. Rightly or wrongly, it is widely accepted that China will continue to grow very rapidly. But what is the likely future for India?

I attended debates on this question in Mumbai and Delhi two weeks ago. The occasion was the launch of a report prepared by the Centennial Group for this year’s Emerging Markets Forum. It addresses a provocative question: what would need to change if India were to become an affluent country in one generation? The answer is: a great deal. But one thing is clear: after the performance of the past three decades, the goal is not laughable.

Since 1980 the average living standards of Chinese and Indians have, for the first time in the histories of these two ancient civilisations, experienced a sustained and rapid rise. In one generation, India’s gross domestic product per head rose by 230 per cent – a trend rate of 4 per cent a year. This would seem a fine accomplishment if China’s had not increased by 1,090 per cent – a trend rate of 8.7 per cent. Yet even if India has lagged behind, the change has been large enough for aspiration to replace resignation as the ethos of a large and rising proportion of Indians.

The remainder of the article can be read here. Debate from our panel of economists appears below.

Becket was murdered. Mr King will not suffer that fate. But a later king of England brought the church and his archbishops to heel. Could the Bank suffer a similar fate?

Indeed, one of the results of this crisis is to imperil central bank independence, not just in the UK. This is so for three reasons: at close to zero official interest rates, the boundary between monetary and fiscal policy erodes; governments are running huge fiscal deficits, particularly in the UK and the US, which threaten monetary stability; and, finally, those in charge wish to divert blame for the disaster.

The remainder of the article can be read here. Debate from our panel of economists appears below.

With one bound the banks are free, or so it seems. Already, the panic of the autumn of 2008 is fading. The period within which lessons can be learnt and changes made is closing. Yet without radical changes, another crisis is certain. It may not even be that long delayed.

In a recent speech, governor Elizabeth Duke of the Federal Reserve told an anecdote from just after the failure of Lehman Brothers last September. Ben Bernanke, chairman of the Federal Reserve, was asked: “Well, what if we don’t do anything?” To which he replied: “There will be no economy on Monday.” Instead, all institutions deemed systemically significant were saved, by shifting almost all of the risk on to taxpayers.

“Never again” might be too much to ask. But “not for a generation” is essential. Governments cannot afford an early repeat, financially, politically, perhaps morally: the lives of so many cannot soon be sacrificed to the whims of a foolish few.

The remainder of the article can be read here. Debate from our panel of economists appears below.

The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.

Is this the beginning of a prolonged economic recovery or a false dawn? There are credible arguments on both sides of the issue. I conjectured over a year ago on these pages that the crisis will end when home prices in the US stabilise. That still appears right. Such prices largely determine the amount of equity in homes – the ultimate collateral for the $11,000bn of US home mortgage debt, a significant share of which is held in the form of asset-backed securities outside the US. Prices are currently being suppressed by a large overhang of vacant houses for sale. Owing to the recent sharp drop in house completions, this overhang is being liquidated in earnest, suggesting prices could start to stabilise in the next several months – although they could drift lower into 2010.

In addition, huge unrecognised losses of US banks still need to be funded. Either a stabilisation of home prices or a further rise in newly created equity value available to US financial intermediaries would address this impediment to recovery.

Global stock markets have rallied so far and so fast this year that it is difficult to imagine they can proceed further at anywhere near their recent pace. But what if, after a correction, they proceeded inexorably higher? That would bolster global balance sheets with large amounts of new equity value and supply banks with the new capital that would allow them to step up lending. Higher share prices would also lead to increased household wealth and spending, and the rising market value of existing corporate assets (proxied by stock prices) relative to their replacement cost would spur new capital investment. Leverage would be materially reduced. A prolonged recovery in global equity prices would thus assist in the lifting of the deflationary forces that still hover over the global economy.

I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets. My hypothesis will be tested in the year ahead. If shares fall back to their early spring lows or worse, I would expect the “green shoots” spotted in recent weeks to wither.

Stock prices, to be sure, are affected by the usual economic gyrations. But, as I noted in March, a significant driver of stock prices is the innate human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it.

For the benevolent scenario above to play out, the short-term dangers of deflation and longer-term dangers of inflation have to be confronted and removed. Excess capacity is temporarily suppressing global prices. But I see inflation as the greater future challenge. If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012; earlier if markets anticipate a prolonged period of elevated money supply. Annual price inflation in the US is significantly correlated (with a 3½-year lag) with annual changes in money supply per unit of capacity.

Inflation is a special concern over the next decade given the pending avalanche of government debt about to be unloaded on world financial markets. The need to finance very large fiscal deficits during the coming years could lead to political pressure on central banks to print money to buy much of the newly issued debt.

The Federal Reserve, when it perceives that the unemployment rate is poised to decline, will presumably start to allow its short-term assets to run off, and either sell its newly acquired bonds, notes and asset-backed securities or, if that proves too disruptive to markets, issue (with congressional approval) Fed debt to sterilise, or counter, what is left of its huge expansion of the monetary base. Thus, interest rates would rise well before the restoration of full employment, a policy that, in the past, has not been viewed favourably by Congress. Moreover, unless US government spending commitments are stretched out or cut back, real interest rates will be likely to rise even more, owing to the need to finance the widening deficit.

Government spending commitments over the next decade are staggering. On top of that, the range of error is particularly large owing to the uncertainties in forecasting Medicare costs. Historically, the US, to limit the likelihood of destructive inflation, relied on a large buffer between the level of federal debt and rough measures of total borrowing capacity. Current debt issuance projections, if realised, will surely place America precariously close to that notional borrowing ceiling. Fears of an eventual significant pick-up in inflation may soon begin to be factored into longer-term US government bond yields, or interest rates. Should real long-term interest rates become chronically elevated, share prices, if history is any guide, will remain suppressed.

The US is faced with the choice of either paring back its budget deficits and monetary base as soon as the current risks of deflation dissipate, or setting the stage for a potential upsurge in inflation. Even absent the inflation threat, there is another potential danger inherent in current US fiscal policy: a major increase in the funding of the US economy through public sector debt. Such a course for fiscal policy is a recipe for the political allocation of capital and an undermining of the process of “creative destruction” – the private sector market competition that is essential to rising standards of living. This paradigm’s reputation has been badly tarnished by recent events. Improvements in financial regulation and supervision, especially in areas of capital adequacy, are necessary. However, for the best chance for worldwide economic growth we must continue to rely on private market forces to allocate capital and other resources. The alternative of political allocation of resources has been tried; and it failed.

The writer is former chairman of the US Federal Reserve

Proposals for reform of financial regulation are now everywhere. The most significant have come from the US, where President Barack Obama’s administration last week put forward a comprehensive, albeit timid, set of ideas. But will such proposals make the system less crisis-prone? My answer is, no. The reason for my pessimism is that the crisis has exacerbated the sector’s weaknesses. It is unlikely that envisaged reforms will offset this danger.

At the heart of the financial industry are highly leveraged businesses. Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely.

The place to start is with the core of modern capitalism: the limited liability, joint-stock company. Big commercial banks were among the most important products of the limited liability revolution. But banks are special sorts of businesses: for them, debt is more than a means of doing business; it is their business. Thus, limited liability is likely to have an exceptionally big impact on their behaviour.

The remainder of the article can be read here. Debate from our panel of economists appears below.