Who pulled the plug on Lehman Brothers?

We must thank Professor Laurence Ball at the Johns Hopkins University for filling a very important information hole on the demise of Lehman Brothers. He has done a wonderful service although, for reasons beyond your control, there are unanswered questions. The decision was taken by Hank Paulson, the then Treasury Secretary, although he had no locus standi to take that call.

Several questions cropped up in my head on reading his 218-page long paper published last year on the bankruptcy of Lehman Brothers:

(1) Is there no consequence for Bernanke not responding to the FCIC request for information on Lehman Collateral and his refusal to provide the information?

(2) When Prof. Ball made the FoIA request for details on the collateral from AIG against which the Federal Reserve lent, it was already 2012. By then, the collateral had been liquidated. Why was it still not feasible for the Federal Reserve to comply with Prof. Ball’s Freedom of Information Act (FoIA) request? It would not have jeopardised price discovery of AIG collateral since they had been liquidated, by then. Pity that the courts too did not agree with him.

(3) I can understand, to a degree, why Hank Paulson did not want to commit public money after the backlash he received for Bear Stearns bailout. But, did it involve taxpayer money? Lending against collateral is the job of a central bank and it is a call that it should take.

To be sure, I agree that if the collateral were of dubious value, then eventually the burden becomes fiscal. But, that is a judgement that the Federal Reserve had to make and the risk of that judgement is part of the job.

In other words, no taxpayer funded bailout should not have meant that Lehman Brothers should be barred from the Fed Primary Dealer Credit Facility (PDCF).

[I learnt from Professor Ball’s interview (see below) that, after Dodd-Frank, the Treasury Secretary has to authorise Fed lending to a stricken institution.]

(4) Why has Hank Paulson not been questioned/tried/fined/ imprisoned for overstepping his authority vs. the Federal Reserve, not to mention yelling at Cox of SEC?

(5) Why has there been no follow-up action to the Financial Crisis Inquiry Commission (FCIC) report in terms of holding public officials accountable for their decisions? The Federal Reserve had dodged information requests from FCIC on the extent of collateral available from Lehman Brothers, on the Fed’s assessment, etc., They were not given that information. Is there no consequence for that?

(6) There is some escape avenue for Paulson because he had tried to arrange a private sector solution. He had spoken to Dick Fuld on fifty occasions between July and September. The paper mentions that. He spoke to Alastair Darling to waive the Financial Services Authority (FSA) insistence on Barclays’ shareholder approval, etc.

But, he could have easily allowed the Fed to fund Lehman for sixty days for Barclays to obtain shareholder approval and let the firm fail, after that, if it did not materialise. That could have also given the system to prepare better?

(7) In an interview for the ‘Promarket’ blog at the Stigler Center at the University of Chicago Booth School of Business, Prof. Laurence Ball specifically rules out ulterior motives for the then Treasury Secretary:

Q: In the aftermath of the crisis, there were rumblings that the reason Lehman was allowed to fail while other institutions were bailed out had something to do with the fact that the government was filled with former competitors of Lehman, and they were the ones calling the shots.

A: I read that. I don’t think that’s really true. There were also stories about Henry Paulson who had been in charge of Goldman Sachs and supposedly didn’t like Richard Fuld, who was head of Lehman Brothers—that may be true, I don’t know, but I think it’s pretty clear that Henry Paulson did not want Lehman Brothers to fail and did not think this was a good thing or tried to get back at his rival on Wall Street. Paulson knew that at best he was taking a very big risk, and he did work very hard to try to arrange for some kind of private sector rescue of Lehman. The last big hope being the Barclays acquisition that didn’t work out, and he was very unhappy. In the end he did everything he could to prevent Lehman’s bankruptcy, whether he liked or didn’t like Richard Fuld. Except he wasn’t willing that the Fed put in money because of the political consequences of that. [Link]

(8) It is funny to see the slant of the interview from the ‘pro-market’ blog. They were trying to argue that the whole crisis was probably much ado about nothing because, had Lehman Brothers been bailed out, it might not have become so serious as it did and therefore what was the fuss really about?!

Never mind that there was a global real estate crisis, bank failures in a few countries in Europe, etc. The interviewers for the blog were trying to argue that the Federal Reserve made a miscalculation and did not rescue Lehman Brothers. They did not want to acknowledge that investment banks were leveraged 40:1 or that Countrywide engaged in predatory lending and that subprime mortgages had grown too much too quickly and that they were securitised multiple times over. None of these constituted a problem. This kind of market fundamentalism is actually repulsive and distasteful.

There is one explanation in their favour. Possibly, they were merely being provocative. That cannot be ruled out.

Those who do not wish to read the 218-page long paper might wish to read this short NYT Deal book article and this 18-page summary paper by Prof. Ball himself.


Answers to questions on my stance on President Trump

A reader had posted the following comment on my  blog few days ago:

I am an avid reader of your blog. I am a faculty in a US engineering school (working in the area of econometrics) and follow economic news with interest. That is how I found your blog and have been reading it for the last few years. In general, I am quite impressed with your articles and am keen to follow your thoughts – for example, I was curious about how you rated the budget. But over the last 6 months your articles on the US election and Trump in general are quite disturbing to me. I have been wanting to respond to your support to Trump.

To clarify, I am right of center in economic policy and quote liberal in religious matters. In India, I support the BJP govt. at center. So, I am not a pseudo-secular guy taking issue here. As a morally upstanding person, how can you support Trump? Forget his economic policy, I have seen all his 15+ debates and never does he come across as a sensible person. I mean he is openly fascist, misogynistic and thin skinned. His statements on John McCain among other things clearly show what kind of a person he is. Given this background, how can you support him? What standards are you setting for leadership if Trump is a good leader? To be sure, I am not blind to the fallacies of NYT and American press and Hilary Clinton. But Trump’s ignorance of facts and his lies should make you question his motives. But I see you support him with little reservation. His cabinet is full of billionaires with no scruples who made money in the financial sector (a group of people you criticize) – so how do you justify your support?

I thank him for engaging rather than giving up on reading the blog in protest. I am not sure that I will be able to answer him convincingly – i.e., persuade him successfully. But, it gives me an opportunity to engage and to sharpen my own understanding of the phenomenon of Trump.

I had written two op.-ed.s in MINT on Trump, the candidate. You can see them here and here. To a large extent, the two columns spell out my reasons and also my reservations. It is not as though the case for Trump, in terms of his personality, was clear-cut. But, that is also his strength.

One of the things I had mentioned in my second column – published on Nov. 8 morning in India – was that with Mr. Trump in office, democratic accountability would be safe, for his every move of hands and lips would be scrutinised microscopically. That is being proven correct, to the point of inciting instability and a breakdown of civil order. In fact, their goal is either an impeachment or worse. The so-called Liberals (illiberals, in reality) might get what they want and I hope they live to regret it deeply.

Whereas with Hillary Clinton, there would not be much scrutiny at all. That was based on the accountability (or, the lack thereof) enforced on President Obama. One only had to read Jeffrey Sachs’ conversation with ‘Project Syndicate’ to understand that. One of the principal reasons – if not the principal reason – for the global refugee crisis has been his botched handling of Libya and Syria. Ms. Clinton was party to at least one of the decisions, if not both.

On Russia, United States has gone back on the promise of NATO non-expansion in Russian sphere of influence. What the United States did in Ukraine was thoroughly objectionable as was the regime change pursued in Syria. President Trump was perfectly correct in posing a question in the O’ Reilly interview if the United States was innocent. Read what Senator Chuck Grassley said about the United States’ interference in elections overseas.

It is not just Jeff Sachs but also Prof. Steve Cohen who has been writing about it and talking about it for quite some time.

How much did the intelligentsia and the media hold Obama accountable when he was in Office and now? Zilch. Nada. Nothing.

On the so-called Russian interference, I think commentators have to decide which way they want to go: Do they want to consider their victory in the popular vote (contributed to by about three counties in California) as legitimate or do they want to say that Russia interfered with and succeeded in changing the final verdict? They cannot have both. The 7-minute interview of former Democratic Congressman (Ohio) Dennis Kucinich for Fox Business News in the ‘Morning with Maria’ programme is worth watching.

On China and as to why the relationship needs a reset, one has to read a lot more to understand the agenda of the new American government. It is not a knee-jerk or impulsive decision. We may not like it and we may think it is unjustified – I, for one, do not – but that is the reality. American relationships with nations are reset at different intervals, depending on their national interest and geo-strategic calculations.

One has to read David Shambaugh’ ‘China’s future’. Robert Luttwak’s book on China (The rise of China vs. the logic of strategy), Richard McGregor’s ‘The Party’, James Kynge’ ‘China shakes the world’, columns by Jamil Anderlini in FT and the regular briefings coming out of the Mercator Institute of China Studies. Or, from the economics angle, read the papers of Peter Schott and Justin R. Pierce. I had blogged on them.

George Yeo, the former Foreign Minister of Singapore spoke to the Harvard Business Association in Hong Kong. While he clearly felt that a conflict between the U.S. and China would not be in the best interests of the rest of the world, he did say the following with respect to China:

China is not like that. This is a civilisation which has deep instincts of its own past and of its own nature. And because of that, China will never harmonise with the rest of the world. Whether we’re talking about cyber space, cultural policy or capital markets, China will never harmonise with the rest of the world. [Link]

Such is their blind hatred for and prejudice against Donald Trump that they could ignore the lessons of history and even contemporary reality and look up to China to uphold liberal order!

It was left to James Kynge to expose their stupidity of hailing Xi Jinping as the champion of the liberal world economic and political order:

Yongjin Zhang, professor of international politics at the University of Bristol, sees a chasm between the way China defines globalisation and the way the wishful high priesthood of global capitalism at Davos wanted to understand it. ..

… But China’s investments and diplomatic alliances are overwhelmingly in the developing world. In this sense, its vision is not global but sub­global; it is aiming to influence those countries where it can make a difference, reap the rewards and remain insulated from western demands to liberalise its political system and inculcate democratic values. [Link]

Of course, China exposed the hollowness of the anti-Trump and pro-China brigade – both moral and intellectual – with its abduction of a businessman from Hong Kong and now, the British and American Universities are getting a taste of their own medicine of intolerance and illiberalism in the name of political correctness and diversity. See here and here. Also, please remember to read Prof. Mark Lilla’s conversation with the Chronicle of Higher Education in January  titled, ‘Campus Identity Politics Is Dooming Liberal Causes. (It could be behind a paywall, though).

Trade Protectionism

On protectionism, it is blithely asserted that technology and not trade that is the problem. That is incorrect. Often repeated, many hope – and they have probably succeeded – that lies would stick. Readers should check out the research of Peter Schott (of Yale University) and Justin R. Pierce of the Federal Reserve on the ‘role’ of China in the crisis of jobs in U.S. manufacturing and in the destruction of communities within the United States.

Many commentators try to appear very erudite by haughtily proclaiming that it was not trade but technology that had led to the employment and other social impacts in U.S. communities. By sheer dint of repetition but not rigour, they seek to establish this as a fact. It is almost impossible to disentangle the effect of trade from technology on U.S. manufacturing employment. Both worked in tandem. It is also difficult to say if technological developments boosted international trade or the other way around. I am sure that there is a bit of both going on. But, trade had an important role to play in the angst that prevails in the United States. That is what the sustained contribution of Schott and Pierce seeks to establish.

Yes, on balance, India and China benefitted considerably (the latter more so) from globalisation but many Americans did not. The American capitalists who profited did not find any reason to nor did the politicians compel them to share their extraordinary prosperity with low-wage workers and others. The result is a clamour for jobs protection. Some of us will be losers but that is inevitable. These things – trade and immigration policies – come and go in cycles. The people to be blamed are not the current President and his administration but the ones who were in office before that and did not do much about the uneven distribution of the benefits of globalisation.

Some – with a bit of conscience – would concede the problem but would assert that Trump’s solutions (to walk back on TPP, for example) would not work and that the situation would be made worse. May be or again, may not. Who knows? Professor Ha-Joon Chang at Cambridge might have different views on it. After all, didn’t these economists predict an economic and financial market meltdown after Brexit but had utterly failed to foresee the real meltdown of 2008?

On immigration

As for immigration, again, many countries have quietly tightened their immigration rules in the last several years, in response to slowing economic growth and vanishing. They may not have spelt out racial or religious criteria but income criteria and they end up affecting a particular country or set of countries or religion.

Similarly, President Trump’s order did not target a particular religion but only citizens of particular countries and that too for a temporary period until some reviews are done. Let us not forget that citizens of many EU states and a considerable chunk of the American population have supported the decision. In fact, only 20% disagreed with the motion that banning would be bad. Quite a large proportion chose to remain silent as some Americans did during the election campaign period.

Of course, it is possible to argue that leaders should not pander to the population’s baser instincts. But, it is even better to ask the question as to why things came to this pass. That responsibility lies with the elites, the previous administration, governments in Europe and with the Muslim community itself. It is wrong to question the manifestation while ignoring the underlying causes. Well, not a surprise because that is what American policy elites have done over the years. Ask the Federal Reserve. They are the experts in that.

On the financial sector

As for the financial sector, yes, I had already done one blog post on President Trump’s appointments and the policy agenda (allegedly) driven by Gary Cohn (ex-Goldman Sachs). I had mentioned this in my column for MINT on November 8 too. This is an area of concern. But, three caveats. One has to wait and see the specific policy decisions taken. Two, one has to make sure that one does not rely on mainstream media to know about them. Three, some of the worst financial sector capture happened in the era of Bill Clinton and Obama and, of course, George W. Bush, Jr. Just sample this story on Mary Jo White, the SEC chair, in the Obama Administration.

Of course, there is a limit to how far one could throw the charge back at the previous government. Trump has been elected to drain the swamp and not clog the drains further with swamp of his own, esp. in the Finance Sector. This one needs watching, for sure.

On Trump’s billionaire cabinet and conflicts of interest

The media is watching like a hawk on the so-called conflicts of interest of his Cabinet with respect to China and other aspects of his policy. So, I will hear plenty of it and that, in itself would be an effective check and balance on them. That said, I would be very careful in basing my conclusions in these polarising matters from the reporting in the mainstream media. His Cabinet members are billionaires and, therefore, they are unlikely to be stupid or self-destructive.

President Trump’s tweets on Nordstrom negotiations or cancellation of its contract with his daughter were unacceptable and, more importantly, stupid. There was no upside to his tweeting on them. Again, perhaps, he is not so stupid as the intellectuals were when they looked up to the Chinese leader to stand up for globalisation and liberal principles. I will come to that in a moment.

As for President Trump’s chaotic first four weeks, read what John Mauldin has to say:

The media will be writing about how Trump can’t keep people and about all the chaos in the White House and other parts of government. But from Trump’s perspective, and given his management style, that’s not necessarily bad in terms of his longer-term goal of changing things.

We have not had a president with this type of management style in my lifetime. Since it’s not something that any of us are going to be familiar with, it is going to make some of us uncomfortable until we get used to it (and some people never will).

If you listen to the media you might have the impression that the Trump transition team is in complete disarray. Talking with leaders of the transition team certainly didn’t leave me with that impression. They have broken the transition process down into over 30 departments and have created a “landing document” for each department. The analogy they are using is that this process is like planning an invasion, and they are going to hand the landing document off to the “beachhead teams” who will then execute the plans.

I was briefly allowed to look at (without actually being able to read) the plan for one cabinet-level department. It appeared to be about 100 pages plus of serious detail as to exactly what executive orders would need to be removed and added, what personnel would have to be replaced (both appointees and regular staff), what policies would need to be changed, and so forth.

I was told that this level of planning was being done for every department. My impression is that there are a lot of people from various think tanks and others with experience in the presidential transition process who are involved in directing the plan for each department. That level of detailed planning doesn’t happen in less than two months. My guess is that some of that thinking has been going on for years, and now it can be implemented.

Steve Moore passed on a story to me. He and my friend Larry Kudlow were meeting with Trump, and Trump asked them if they would like to be part of his economic advisory team during the campaign. They looked at each other and back at Mr. Trump and said something to the effect of, “You can’t use us. We believe in free trade.” And Trump then said, “But we agree on nearly everything else. Let’s agree to disagree on trade and figure out where we can work together.”

Not many presidents are willing to have that level of disagreement from the outset. That is somewhat comforting to me. [Link]

In the same speech, referred to earlier, George Yeo, like John Mauldin and Dr. S. Jaishankar, India’s foreign secretary, had some sensible advice to offer on how to understand President Trump:

We do know that Mr Trump has certain deep instincts. He sees a lot of problems in American society. He wants to reinvigorate it. So trade has to be fair, in his mind. I’m not sure it’s going to help just by arm twisting automobile companies to manufacture in the US, because the global economy is much more complicated than that.

But it does win him applause from the gallery, and some things we must expect him to do for political reasons. As he himself has said, he’s from Wharton, so he can’t be stupid. And he’s not. To think that he is would be a serious miscalculation.

He says, ‘Look, we got to deregulate’. He wants to simplify the tax code and reduce the general level of taxation. He wants to revamp infrastructure in America, much of which has gone to disrepair. And that’s the right direction to go. He wants to control the borders better. Again, he may have made outrageous remarks, but the deep intention is, ‘We’ve got to have a handle on illegal immigration, and also to control conduits which may bring in radicals and terrorists’.

But there are two things which are troubling. One, it is easy to spend, it’s easy to reduce taxes, people would cheer you. But how do you cover the deficit? The other area which is a bit troubling is what appears to be a very deep conflict between Mr Trump and the intelligence agencies. He has become very distrustful of them.

And he takes a practical approach towards international security. Must we interfere in Syria? Was it right – Iraq, Libya, and the cornering of Russia? Maybe this is driving them into the arms of China. Does it make sense?

There are many people whose entire careers are formed on certain perspective and he’s challenging them. It’s important to get past the common criticisms against Mr Trump, quoting him against him, laughing at some of his inanities, and ignoring his deep purposes. I think it’s much more important to look at his deep purposes because he’s not a man to be disregarded. [Link]

Penultimate point

I am not seeking a spiritual guru to demand an upright moral code. I am being realistic. Not too many contemporary politicians would pass the test. There is very little to choose between them. Lying is a policy and political instrument. Further, I have no idea as to who is lying – either the President or those who call him a liar. The mainstream American media and the world over carry a far less trust quotient than the current American President.

Final point

Just consider this: four more years of the failed policies of the last three and half decades would have made the world more dangerous, more unstable and more fertile for a real demagogue and a fascist.

The biggest charge (a criminal one at that) against many of those who rail against Trump is that they did not call out the egregious excesses and wrong things that were going on in the world in the name of globalisation and liberal world order. Even now, there is no admission of guilt, let alone contrition. Instead, they are gunning for President Trump, who is the consequence of all that went wrong.

The world is where it is today – feeling unsafe, unsure and uncertain – not because of him because he has been in office for less than thirty days but because of what has been going on for the last thirty years.

As they seek to destroy President Trump and his agenda, they are seeking to destroy their own creation. But, if they succeed in doing so, they will only be removing the manifestation or the symbol of their acts and crimes of omission and commission.  They will feel vindicated. They will go back to their old ways. Nothing in their behaviour before and after the election in America, before and after the Brexit referendum suggest that they have learnt the lessons, least of all, the lesson of humility. That is the biggest danger to the rest of the world. Not President Trump or his policies.

Good reads from December

Barry Eichengreen thinks that James Galbraith’s ‘The Age of Uncertainty’ of the Seventies would be more like the ‘Age of assurance’ compared to today’s situation.

Michael Boskin on the lessons of the American election: he mentions the inability of people, in general, to cope with rapid change and “growing opioid epidemic and a tedious and intolerant form of political correctness,..”

Mohamed El-Erian argues that growing internal tensions and contradictions, together with over-reliance on monetary policy, are destabilizing the mediocre or new normal that he propounded years ago. But, his structural reforms do not sound like structural reforms, though. They are too easy.

Chris Patten does well to inveigh against the closing of the academic mind. There is not much to choose between some campuses in the West and authoritarian governments in other parts of the world.


Follow-up to Gillian Tett

Just little over 24 hours after I posted the comment on Gillian Tett drawing attention to the ‘financial markets’ elephant in the room, I came across two very good pieces that underscore the points made in that post.

One is from Bawerk.net. It has got four terrific charts. The conclusion is spot on:

Years of capital consumption have led to peak debt whereby each additional unit of debt reduces economic growth instead of artificially stimulating it. There is only one way out of this, and that is a wholesale admission that current policies of extend and pretend is no longer working; unfortunately only real crisis seem to focus minds enough to implement necessary changes. Until then, the painful slog will continue. Our dire prediction for the future is simply one where the confluence of a struggling middle class and politics jointly forces through some sort of structural change. These usually makes things much worse before the system reset toward a more sustainable path. Upcoming elections in Italy, the US, the Netherlands, France, Germany and Spain in a post-Brexit environment provide ample opportunity for radical change.

The need for making things worse reminded me of my column in MINT a month or so ago on why America needed a Trump Presidency.

Also, would like to recommend for reading this post by Edward Harrison at ‘Credit Writedowns’: ‘The new normal that never was’. It is not as direct as the one by Bawerk but it has some interesting charts and points to the divergence between financial asset prices and the real economy in the post-2008 QE inspired world.

All in a day of God’s work

The settlement includes an agreed-upon statement of facts that describes how Goldman Sachs made multiple representations to RMBS investors about the quality of the mortgage loans it securitized and sold to investors, its process for screening out questionable loans, and its process for qualifying loan originators.  Contrary to those representations, Goldman Sachs securitized and sold RMBS backed by large numbers of loans from originators whose mortgage loans contained material defects.

In the statement of facts, Goldman Sachs acknowledges that it securitized thousands of Alt-A, and subprime mortgage loans and sold the resulting residential mortgage-backed securities (“RMBS”) to investors for tens of billions of dollars.  During the course of its due diligence process, Goldman Sachs received pertinent information indicating that significant percentages of the loans reviewed did not conform to the representations it made to investors.  Goldman also received and failed to disclose negative information that it obtained regarding the originators’ business practices.  Indeed, Goldman’s due diligence vendors provided Goldman with reports reflecting that the vendors had graded significant numbers and percentages of sampled loans as EV3s, i.e., not in compliance with originator underwriting guidelines.  In certain circumstances, Goldman reevaluated loan grades and directed that such loans be waived into the pools to be purchased or securitized.

Even when the percentage of problematic loans in pools sampled by it vendors indicated that the unsampled portions of the pools likely contained additional such loans, Goldman typically did not increase the size of the sample or review the unsampled portions of the pools to identify and eliminate any additional such loans.   In many cases, 80 percent or more of the loans in the loan pools Goldman purchased and securitized were not sampled for credit and compliance due diligence.  Nevertheless, Goldman approved various offerings for securitization without requiring further due diligence to determine whether the remaining loans in the deal contained defects.  A Goldman employee overseeing due diligence for a particular loan pool noted that the pool included loans originated with “[e]xtremely aggressive underwriting” and “large program exceptions made without compensating factors.”  Despite this observation, Goldman did not review the remaining portion of the pool, and subsequently securitized thousands of loans from the pool.

Goldman made statements to investors in offering documents and in certain other marketing materials regarding its process for reviewing and approving originators, yet it failed to disclose  to investors negative information it obtained about mortgage loan originators and its practice of securitizing loans from suspended originators.

Beginning in mid-2006, Goldman recognized that Fremont, a “key originator, was experiencing an increasing level of early payment defaults (“EPDs”) (i.e., loans for which the borrowers had failed to make one or more of their first payments).  Goldman was aware that EPDs were a sign of originators’ bad credit decisions and could be indicators of potential borrower fraud.  However, Goldman did not put Fremont on its “no bid” list and continued to purchase loan pools from Fremont during the period Fremont’s EPD claims remained unpaid.  Moreover, Goldman “[u]ndertook a significant marketing effort” to tell investors about what Goldman called Fremont’s “commitment to loan quality over volume” and “significant enhancements to Fremont underwriting guidelines.”    Likewise, Goldman identified issues with Countrywide’s origination practices.  Goldman’s head of due diligence, when presented with a “very bullish” equity report on Countrywide, another large originator, exclaimed “[i]f they only knew  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .”

From the press release: “A.G. Schneiderman-Led State & Federal Working Group Announces $5 Billion Settlement With Goldman Sachs” [Link]

Eisman on Greenspan

‘THE CEOS ARE CLUELESS’: The FCIC staff interviewed Steve Eisman of FrontPoint LLC — who figured in “The Big Short.”

“He said that CDOs and CDS `are an important story,’ but not necessarily the central story to the financial crisis. He said that fundamental causes of the crisis started in the 1990s with two big events: 1) the shift to measuring leverage on a risk-weighted basis, and 2) the creation of the shadow banking system….

“Mr. Eisman added that `Alan Greenspan is the worst Chairman of the Fed in history,’ and that he allowed `basically no regulation whatsoever and basically allows a shadow banking system [to grow] which is a way, really, to get things off balance sheets, to hide risk, to keep risk away from regulators.’ Kim asked how Mr. Eisman defined shadow banking, and he replied that `anything not on a bank balance sheet’ is shadow banking….

“Kim asked if he recommended talking to anyone else. Mr. Eisman said, `I know for a fact people went to Greenspan and said, “these loans are really bad and will one day have really bad social results.”  [Link]

Gods of financial liberalisation

In its country report no. 15/62 [(‘India: Selected Issues (March 2015)], there is a chapter on spillover from surges in global financial market volatility. Its conclusions are worth noting and internalising:

The key findings of this chapter are as follows:

  • We confirm Rey’s (2013) view that there is a global financial cycle in capital flows and asset prices, as derived from our GVAR modeling framework.
  • We show that global financial market volatility (e.g. induced by monetary policy normalization uncertainty in advanced economies) has significant spillovers to emerging market economies (operating through trade and financial linkages, global liquidity and portfolio rebalancing channels).
  • We observe that there are heterogeneities across countries in their responses to a surge in global financial market volatility. This would reflect the scale of EMs’ trade and financial exposures to AMs, their individual cyclical positions, and their internal/external imbalances.
  • Consistent with Rajan (2014), we conclude that a prolonged term-premium compression raises financial stability concerns as the magnitude of financial spillovers has become larger over time, while asset prices and interest rates have become more correlated globally during the period of unprecedented monetary easing by advanced economies (see Figure 2).
  • We argue that strong fundamentals and sound policy frameworks per se are not enough to isolate countries from an increase in global financial market volatility. This is particularly the case where there is a sudden adjustment of expectations triggered by monetary policy normalization uncertainly in advanced economies. This argument is supported by the impulse responses in Figure 3, where no country (neither AMs nor EMs) appears immune from the impact of a surge in global financial market volatility.

There is a global cycle in capital flows; regardless of fundamentals being good, all countries are affected. There is a hetoregenity of impact on countries and therefore, differentiated policies on interest rates and capital flows are required. It is obvious that there is ‘no one size fits all’ approach.

That is why it was rather strange to note Mr. Ajay Shah, Professor at NIPFP writing as follows in his blog post on March 2:

By this time, serious people in Indian macro/finance knew where India needed to go: Inflation target + Open capital account + Floating exchange rate. All the other expert committee reports supported this. [Link]

If expert committees appointed in India have recommended these, then one must remember that they were a product of the times during which these were unquestioned. Now, all three have been proven to be wrong and dangerous, if taken to a cultish extreme. The conclusions of the IMF study cited above is but the latest example of the rethinking, induced by real world developments. We in India seem to think that the clock stopped in 2007 and that all needed to be learnt on monetary policy, capital flows and foreign exchange were learnt before that.

Open Capital Account + Inflation Targeting + Floating Exchange rates – all three are wrong at worst and, at the minimum, need to be context-specific and based on responses and policies of other countries on their capital accounts and their currencies.

Inflation targeting blinded the West to credit and financial market excesses before 2008 and they are at it, again. That is why India’s adoption of an inflation targeting regime at this stage, seems utterly misguided and unnecessary and second, taking into account India’s unique circumstances (supply rigidities caused by government intervention and high component of food in CPI basket), represents an unfair distribution of responsibility for meeting the inflation target between the Government and the Central Bank.

The IMF that battled for free and unrestricted capital flows in the 1990s has substantially modified its stance on capital flows. It advocates capital controls. Jonathan Kirshner’s ‘American Power after the Financial Crisis‘ has a riveting account of the efforts made by the US Treasury under Robert Rubin and Larry Summers (mostly during his period), egged on by Wall Street, to include a commitment to free capital flows in the IMF charter.

Now, it has not only dropped that but also turned around to accepting the usefulness of capital controls. In fact, the Independent Evaluation Office of IMF has noted that the Fund has been more open in advising member-countries on the usefulness of capital control measures than it had done so in its 2012 paper linked above.

This blog post has a useful summary of issues on which the Fund has now become intellectually more flexible while some folks in India have hardened their stances and are pushing the country in the wrong direction. Unfortunately, their views are being heard too seriously and not with the degree of scepticism that is both warranted and suggested by empirical developments elsewhere in the world.

India can have truly floating exchange rates if every other country has a genuinely floating exchange rate. QE is nothing but exchange rate manipulation and the RBI Governor is correct to say that emerging markets, adopting QE policies, would have been labelled currency manipulators by the US Treasury Department. The Federal Reserve Board, the European Central Bank and the Bank of Japan have been at it for quite some time now and the intent is to free ride on external demand through cheaper exchange rates. Bank of England did so too. That they have not succeeded is altogether different matter. Now, China may follow these big three with its own QE and currency devaluation down the road. I had discussed these potential moves by China in my recent column in MINT and have a detailed discussion document coming up at Takshashila Institution.

Given this backdrop of unprecedented global monetary easing and ‘beggar thy neighbour’ exchange rate policies, it was rather amusing to note the observation in this blog post that India’s foreign exchange intervention has increased under the current RBI Governor as though it was a crime!

Proponents of financial, foreign exchange and capital account liberalisation policies must wake up and smell the coffee instead of dragging a largely underinformed and uninformed country into the dangerous wild west land of finance driving the real economy. The world is trying to move forward into a saner and more stable policy setting with regard to the financial sector whereas India is being dragged backward, as usual. India should examine the efforts being contemplated by Iceland. There is no point in making India go through the horrible experiences that Western nations endured before turning to sensible and prudent oversight and regulation of the financial sector.

Finance must remain the handmaiden of the real economy and policymakers should not become the handmaidens of the financial sector.