Kevin Gallagher on Emerging Markets and Re-regulation of Cross-Border Finance

"Since the revival of global capital markets in the 1960s, cross-border capital flows have increased by orders of magnitude, so much so that international asset positions now outstrip global economic output. Most cross-border capital flows occur among industrialized nations, but emerging markets are increasing participants in the globalization of capital flows..."

New Levy Working Paper: Shadow Banking - Policy Challenges for Central Banks

By Thorvald Grung Moe*

Central banks responded with exceptional liquidity support during the financial crisis to prevent a systemic meltdown. They broadened their tool kit and extended liquidity support to non-banks and key financial markets. Many want central banks to embrace this expanded role as “market maker of last resort” going forward. This would provide a liquidity backstop for systemically important markets and the shadow banking system that is deeply integrated with these markets. But how much liquidity support can central banks provide to the shadow banking system without risking their balance sheets? I discuss the expanding role of the shadow banking sector and the key drivers behind its growing importance. There are close parallels between the growth of shadow banking before the recent financial crisis and earlier financial crises, with rapid growth in near monies as a common feature. This ebb and flow of shadow-banking-type liabilities are indeed an ingrained part of our advanced financial system. We need to reflect and consider whether official sector liquidity should be mobilized to stem a future breakdown in private shadow banking markets. Central banks should be especially concerned about providing liquidity support to financial markets without any form of structural reform. It would indeed be ironic if central banks were to declare victory in the fight against too-big-to-fail institutions, just to end up bankrolling too-big-to-fail financial markets.

Read rest here.

*Thorvald Grung Moe is a senior adviser at Norges Bank.

Gerald Epstein: Too-Big-To-Fail Advantage Remains Intact For Big Banks

Gerald Epstein:

Yeah, well, I think there are some noteworthy things. First of all, just to explain what this means, what it means is that these largest banks, like Bank of America, Goldman Sachs, JPMorgan, and so forth get an advantage when they borrow money in the financial markets, because the people who lend them money believe that if they get into trouble, the government will bail them out, that the taxpayers will bail them out. And this has been known since at least 1984, when Continental Illinois Bank almost went under and the government bailed them out, and then the government said, well, we're going to bail out the 11 biggest banks that are too big to fail, and we're going to bail them out in the future. And, of course, that's exactly what happened in the financial crisis of 2007-2008. So when investors lend money to these big banks, we've thought for a long time that they expect that they're going to get bailed out if they get into trouble, so they'll charge less money to these big banks...

Dean Baker on The Checkered Past of Ben Bernanke

By Dean Baker

The retrospectives of Ben Bernanke on his leaving the Fed seem to be coming in overly positive. While there is much that is positive about his tenure as Fed chair, many of these accounts have a rather selective view of history.
The part that is clearly wrong is treating Bernanke as a bookish academic who got plucked down in the middle of a financial crisis that was not his making. While Bernanke had a distinguished academic career, he had been in the middle of the action in Washington since 2002. That was when he was selected to be a governor of the Fed. He served as a governor at Greenspan’s side until he went to serve as head of President Bush’s Council of Economic Advisers in June of 2005. After a brief stint as the chief economist in the Bush administration he returned to take over as chair of the Fed in January of 2006.
It was during the period that Bernanke was at the Fed and his tenure in the Bush administration that the housing bubble grew to such dangerous levels. While Bernanke does not deserve as much blame for this as Greenspan, there were few people better positioned to try to deflate the housing bubble before it posed such a large risk to the economy. During this time Bernanke was dismissive of suggestions that the unprecedented run-up in house prices posed any problem. There is no evidence that he dissented in any important way from Greenspan’s view that the Fed need not be concerned about the housing bubble or the innovations in the financial industry that was supporting it.

Read rest here

G-24 Policy Brief: Capital Flow Management and the Trans-Pacific Partnership Agreement

A recent Global Economic Governance Initiative (GEGI) G-24 policy brief by Kevin P. Gallagher, Anna Maria Viterbo, and Sarah Anderson asses the degree to which the final draft of Obama's TPP (Trans-Pacific Partnership) deal must include significant safeguards to prevent and mitigate financial crises. The authors provide an alternative legal language that could be incorporated in future trade deals such that nations have the space and flexibility requisite to ensure financial stability. In my view, however, it is perhaps highly unlikely that the power brokers of TPP would even consider or critically reflect on the far-reaching proposals. From the Intro:

The Trans Pacific Partnership (TPP) being negotiated by 12 governments represents an important opportunity for a fresh approach to the treatment of capital flow management measures in trade agreements. Most regional and bilateral free trade agreements (FTAs) and bilateral investment treaties (BITs) enacted in the past two decades have encouraged capital account liberalization based on the view that this policy choice would facilitate more efficient international allocation of resources and spur foreign investment and growth in developing countries. In recent years, however, there has been a major re-thinking on the issue of capital account liberalization. In December 2012, the International Monetary Fund (IMF) issued a new “institutional view” that endorses the regulation of cross-border finance in some circumstances. The IMF also pointed out that many trade and investment treaties do not provide the appropriate level of policy space to regulate cross-border finance when needed. While the IMF’s new position was the outcome of many years of analysis, it was no doubt influenced by the 2008 financial crisis and the fact that a number of governments have used various forms of capital flow management measures (CFMs) in recent years to address financial volatility. The Trans-Pacific Partnership, as the first major trade negotiations since the 2008 crisis, presents an important arena to ensure coherence between current thinking on CFMs, including the IMF’s “new view," and trade and investment agreements.

Read rest here.

New Title: The Handbook of the Political Economy of Financial Crises

From the abstract:

The Great Financial Crisis that began in 2007-2008 reminds us with devastating force that financial instability and crises are endemic to capitalist economies that lack powerful and dynamically changing financial regulations that can keep the powerful forces of leverage and credit within sustainable bounds. Economists from Marx to Keynes, and Minsky to Kindleberger have well understood this profoundly important fact, yet the dominant mainstream economics of "rational expectations", "efficient markets" and "laissez-faire" that rationalized widespread financial liberalization and still dominates the economics profession has gotten it, literally, "dead wrong". The Handbook of The Political Economy of Financial Crises describes the theoretical, institutional, and historical factors that can help us understand the forces that create financial crises - with an emphasis on the crisis of 2007- 2008 - and the strengths and weaknesses of varying theoretical perspectives and policy approaches that have tried to comprehend and limit these financial tsunamis.

See more here.

NOTE: Although all of the chapters will be invaluable to the reader, one in particular that will be worth much perusing is by Prof. James Crotty on the irrelevance of efficient market hypothesis (EMH), which can preliminarily be seen here .

Jan Kregel: The Continuing Risk of Derivatives

Yves Smith and Dean Baker on the Trans-Pacific Partnership Agreement

The Trans-Pacific Partnership Agreement (TPP) is a somewhat secretive Free Trade Agreement that the US and several Asian and Latin American countries are negotiating. In the short part below Yves Smith (from Naked Capitalism) talks about the restrictions on financial regulations and capital controls that the agreement would impose.

Watch the whole interview conducted by Bill Moyers here. A similar take by Kevin Gallagher here.

Avinash Persaud on the risks of bail-ins

A bail-out is when an outside entity, like external investors, a central bank or an international organization like the IMF, rescues an indebted bank or firm or even a country by injecting money. A bail-in, in contrast is when the creditors are also forced to bear some of the burden of the adjustment. Persaud, a well known financial economist, has recently argued (subscription required) that contingent convertible notes, known as CoCos, convertible notes that can be converted into equity according to specified events, and that "automatically bail-in creditors when banks run into trouble" are no better then fool's gold.

Why should we care? Here is an insider of financial markets, that worked at JP-Morgan in the 1990s, and was a member of the UN Commission of Experts on Reforms of the International Monetary and Financial System (the so-called Stiglitz Commission; Report here), suggesting that these instruments "are a throwback to the failed philosophy at the heart of the 2004 Basel II global banking rules, which made the market pricing of risk the frontline of defense against financial crises." And we know how well that worked.

Not only the recovery in developed countries is anemic, as a result of widespread austerity, but also lax regulation, and excessive risk taking are still the norm.

How much is JP Morgan really paying for their fraud?

If you read the news it seems that JP-Morgan Chase, the biggest US bank, has agreed to pay US$13 billions on fraud charges for their mortgage practices leading up to the financial crisis. Bill Black, author of the fantastic and properly titled book The Best Way to Rob a Bank Is to Own One, argues that the number is inaccurate.

So more like US$6 billions. Out of profits of more than US$20 last year, and god knows of how much they made out of their fraudulent practices.

See the full interview from the Real News Network here.

Larry Summers as Ineffectual Regulator: Tall Tales From the White House

From Dean Baker:

The Obama administration push to get Larry Summers as Federal Reserve Board Chair is moving into overdrive, as they pull out all the stops. Last week they gave the public the story of Larry Summers as a prescient but frustrated regulator. Summers saw the problems in the subprime housing market way back in 2000, but couldn’t get anything through an obstructionist Republican Congress.

Exhibit A in this story is a joint report on predatory lending by the Treasury Department and the Department of Housing and Urban Development (HUD) that was issued in June of 2000, back when Larry Summers was Treasury Secretary. The report lists many of the abuses that underlie the explosion of bad loans in the housing bubble years.  Unfortunately the report’s recommendations were blocked...

Read Rest here.

The US as a Global Risk Generator

By Kevin Gallagher

The U.S. economy continues to have a hard time recovering from the biggest financial crisis since the Great Depression.

So the last thing one would expect the U.S. government to do is to engage in policies that open the floodgates to severe risks in financial markets once again.

And yet, that is precisely what's going on.

For all the attention that is paid to the Federal Reserve's "tapering," what Washington has in its crosshairs is something quite different.

It is putting massive pressure on the Commodity Futures Trading Commission (CFTC) and the Security and Exchange Commission (SEC).

Unless concerned policymakers — and the public at large — act quickly to counter that pressure, the disastrous past — a financial industry running amok — may well be not just be the United States' national, but our common global future.

How is this even possible?

Even though the U.S. Congress passed the Dodd-Frank financial reform law a few years ago as a bulwark against reoccurring financial crises, the legislation actually left most of the key decisions — the actual detailed rule-making to rein in the financial industry — for later.

Read the rest at The Globalist.

IMF's New View on Capital Controls

By Kevin P. Gallagher and Jose Antonio Ocampo

"Weeks before the spring meetings of the International Monetary Fund (IMF) in Washington next month, GDAE Senior Researcher Kevin P. Gallagher and Colombia University economist Jose Antonio Ocampo offer a critical analysis of the IMF's new view on capital account liberalization and the management of capital flows. The article, “The IMF’s New View on Capital Controls,” appears in India's Economic and Political Weekly (see here).

In the 1970s the International Monetary Fund became an advocate of capital account liberalization, and in 1997 it tried to change its Articles of Agreement to include capital account convertibility among its mandates. In contrast, the IMF embraced in December 2012 a new "institutional view" on this issue. While it remains wedded to eventual financial liberalization, it now acknowledges that free movement of capital rests on a weak intellectual foundation. Gallagher and Ocampo claim that this is a step in the right direction, but that the new institutional view still suffers from a number of shortcomings that will need to be addressed in national capitals and in other international fora.

Although a significant step forward, the new institutional view is still out of step with country experience and economic thinking in many respects. In particular, it continues to insist on eventual capital market liberalization despite the lack of evidence supporting it, is too narrow concerning the sanctioned use of capital account regulations on inflows and outflows, and does not deal with the implications for multilateral aspects of regulating cross-border finance."

Let’s not get ‘carried away’ by Bernanke’s latest twist

By Kevin P. Gallagher

Ben Bernanke, chairman of the US Federal Reserve, should be applauded for boldly putting employment over price stability in his latest move to keep interest rates low and to purchase mortgage-backed securities. Bernanke’s critics (and Bernanke himself) have rightly said that monetary policy is not enough, however. To truly generate employment-led growth in the US, those critics say more fiscal policy is needed.

There is also a need for stronger financial regulation in order to ensure that financial institutions do not steer newfound liquidity into currency and commodity speculation in emerging markets and developing countries—speculation that can wreak havoc on developing countries’ financial systems and growth prospects. Such was the case during previous rounds of interest rate declines and quantitative easing in the US, and could occur again.

Investors may choose not to go down Bernanke’s path but rather to use the carry trade to speculate on foreign currencies. The carry trade is a strategy where investors borrow in low interest rate countries and invest in higher interest rate countries with the “carry” being the difference between the two rates. Profits can increase by orders of magnitude if investors are significantly leveraged and bet against the funding country and on the target country currency.

Earlier this year, the IMF reported that lower interest rates in the US and higher economic growth in emerging markets were associated with a higher probability of a capital inflow “surge”. Surges in capital inflows can cause currency appreciation and asset bubbles that can make exports more expensive and destabilise domestic financial systems. According to that IMF report, one third of the time such surges were accompanied by a sudden reversal of capital flows.

The IMF’s 2011 World Economic Outlook report documents how a “sudden stop” in capital flows can unwind emerging markets and developing economies as well. They show that a 5 basis point increase in US rates could cause capital flight worth 0.5-1.25 per cent of GDP out of the developing world. This is not a short-term problem given that Bernanke has committed to keeping rates low into the future. However, global risk aversion, such as continued euro jitters, can also cause sudden reversals of capital flows.

In 2010 and 2011, many emerging markets and developing countries deployed counter-cyclical capital account regulations such as taxes on inflows or reserve requirements on derivatives transactions to curb the negative effects of cross-border capital volatility. Like earlier studies by the National Bureau of Economic Research and others confirming that regulating capital flows can change the composition of inflows, make for more independent monetary policy and ease exchange rate tensions, new studies by the IMF and others show how countries such as Brazil, Taiwan and South Korea have been at least moderately successful during this recent go-around.

Echoing but formalising work that dates back to Keynes, a new IMF report finds that industrialised countries may need to regulate the outflow of capital as well. The new IMF paper, “Multilateral Aspects of Managing the Capital Account”, argues that when regulating capital inflows is costly or relatively ineffective for borrowing countries, or if the proper regulation would cost too much “collateral damage”, then nations such as the US may need to regulate the outflow of capital.

It may come as a big surprise to learn that the US regulated outflows of speculative capital for close to 10 years, 1963 to 1973. During that period the US administered the Interest Equalisation Tax (IET). The IET was a 15 per cent tax on the purchase of foreign equities. For bond trades the tax variety depending on the maturity structure of the bond, ranging from 2.75 per cent on a three-year bond and up to 15 per cent on a 28.5 year bond. Borrowers looking to float bonds would thus pay approximately 1 per cent more than interest rates in the US, thereby flattening the interest rate differential between the US and Europe.

The proposed Volker Rule would make it harder for US banks to speculate on foreign countries via the carry trade with US deposits. However, an increasing amount of carry trade transactions occur outside the commercial banking system. Moreover, financial interests have led to measures in US trade treaties that make it illegal for trading partners to regulate cross-border finance as well.

Later this autumn, the IMF is set to release a new set of guidelines that will reiterate the need to regulate global financial flows. The fund would do well to incorporate its latest work that shows how industrialised nations may need to regulate capital flows as well. Doing so will help nations across the global economy, regardless of their level of development, achieve their stated economic goals without getting “carried away” by footloose finance.

Published originally here.

We need a Public Rating Agency!

So Standard & Poor's has revised the outlook of US debt, which is still triple-A, to negative. The reason according to their report is that: they “believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges.” Basically, the economic rationale is simply that the fiscal consolidation (read contraction) plans are not strong enough. Somebody should explain to them that the US cannot default on debt denominated in dollars. There is always recourse to monetization of debt in your own currency. And yes monetization may have consequences. But, monetization would only lead to inflation if the economy were at full employment. I wish we were there, and excess demand could lead to inflation. But at this point it’s pure delusion.

Note, however, that all the Rating Agencies (S&P's, Moody’s and Fitch) argue, to protect against lawsuits, that their ratings are nothing more than opinions. By the way, the opinions of people that rated subprime CDOs (Collateralized Debt Obligations) as triple-A. These are the opinions of highly unqualified people at best, or worst just completely dishonest. It would be nice if we could just dismiss their ‘opinions’ as the ranting (not ratings) of lunatics and common thieves, but that would be dangerous.

In fact, their views are not just opinions, and their argument is disingenuous at best. The problem is NOT that investors actually pay attention to their ratings, which they do. Worse than that, financial regulations incorporate their ratings and require, for example, that money-market funds have to invest in instruments with high credit ratings. Several laws require pension funds to meet certain credit-rating requirements, and banking regulations determine regulatory capital requirements based on the credit ratings of the securities the bank owns. In other words, the credit agencies have a semi-public status, but they are profit-making businesses, which have a proven record of incompetence (when it comes to risk assessment, not profit-making). This is the strongest case for creating a public rating agency that would be free from the conflicts of interest that the private agencies are so obviously entangled into.