Friday, January 15, 2010

My favorite financial reform perspective, infrastucture bank, not losing your luggage on planes, and the best time to do things

I've promised links posts would be rare, and have now made three in three days. I apologize... this won't continue! However, the Pettis link was too good to give up, and the rest of it was interesting and unusual as well.

Michael Pettis is probably my favorite blogger, edging out Mankiw and Cowen. He's a Chinese economics expert, and is second to none in his deep understanding of Chinese financial economics and macroeconomics. Here, he talks about currency pressure, the potential for trade hostility and US demand for goods. He's worth spending time on. (Hat tip to Paul for the recommendation). I quote liberally below, only because I agree with it so strongly:

"If we were to see a break in the [Chinese] housing bubble, there are broadly speaking two ways to address the problem.  The so-called "Anglo-Saxon" model would involve a rapid liquidation of loans, the seizing and selling of collateral, and bankruptcies.  The advantage of this model is that assets are quickly re-priced and allocated to their most profitable or efficient uses.  

Assets that are non-viable at their original costs, in other words, are marked down and returned to the economy, and very often the new users engage in rapid innovation and the creation of new industries.  One obvious example is the massive railroad bankruptcies that occurred in the US after 1873.  The railroads were liquidated and purchased by new investors at steep discounts, allowing them to cut freight costs sharply, thereby spurring a whole series of new industries, most famously, I think, the mail-order retail business.  More recently the collapse of the broadband suppliers and the subsequent drop in internet costs permitted the existence of, Ebay, Google and a host of other new technology companies.

But there is a cost.  Liquidation can be brutal – businesses close down, land and assets are seized, workers lose jobs, families are forced to leave their homes, and so on.  Americans, for whatever reason, have been more tolerant than many other societies of these kinds of disruptions, perhaps because of a combination of innate optimism and a robust political framework that absorbs some of the costs and anger.  Other societies are less so.

The second way, broadly speaking, that the break in the housing bubble might occur, and without the brutal social adjustments, is what has sometimes been called the "Japanese" model.  Rather than force bankruptcies and rapid liquidation, borrowers would be permitted easily to roll over their loans, financing costs would be kept low (at savers' expense of course), and excess inventory taken off the market.  The disadvantage of this kind of process is that assets are very slowly reallocated – sometimes after many years – to more efficient uses, and those assets taken off the market become a pure dead-weight to the economy.  In addition the need to keep financing costs low, so as to delay recognition of the losses, hampers future growth by encouraging continued misallocation of capital and slowing the development of domestic consumption by forcing households to bear most of the cost of the adjustment via low interest rates on their savings.  The advantage, of course, is that it much less socially disruptive and painful...

...Financial crises are usually the way a distorted system rebalances, and although they are often necessary in the long run, they can obviously be painful in the short.   Needless to say there is nothing like a financial crisis to bring out calls for the reform of the financial system, but I think we should be very cautious about what kinds of reform we ask for.  The recent financial crisis, which seemed most to affect "Anglo-Saxon" financial systems, have brought out, predictably enough, fervent warnings about the riskiness of deregulated and fragmented financial systems, along with a pride of proposals for reform, many of which aim to prod and force financial systems into more rigid and constrained forms.

But we risk, as always, drawing the wrong lessons from the crisis, and confusing the triggers with the underlying causes of the crisis.  Every major financial financial crisis in history was preceded by a massive liquidity build-up. which the financial sector was forced to accommodate, as it always does, by taking on too much risk.  Hyman Minsky, and his disciples like Charles Kindleberg, describe this process vividly, with banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital.  It doesn't matter if the system is highly fragmented and deregulated or highly regulated and monolithic.  After all a large part of the prestige of the "Anglo-Saxon" model derives from the spectacular collapse of its antithesis, the Japanese model of the 1980s, which seemed — mistakenly again — to prove the superiority of deregulated systems, with their breakneck innovation, over highly regulated and very rigid systems.

So which is it that can best prevent crisis and the associated economic costs — the very open systems or the very rigid systems?  Neither, it turns out.  All of them react more or less the same way to excessive liquidity and too-cheap capital — by taking on too much risk, whether in the form of complex derivatives and securitizations, in the case of the former, or in the form of very old fashioned collateralized loans, in the case of the latter.

So is there no room for financial sector reform?  Of course there is, but the purpose of reform should not be to allow us to turn from the crisis and proclaim "Never again!"  That is silly.  It will happen again and again and again.  Instead, the purpose of regulation should be to ensure that the financial system does a better job of allocating capital during "normal" periods.  A financial system designed to minimize the risks of crisis is probably a waste of time.  It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run.   Periodic financial crises are a necessary evil, and there is little we can do about them except try to create automatic structures (counter-cyclical in national balance sheets, as Mnsky argued) that minimize their transmissions into the real economy.   So in China's case, contrary to breathless advice by press and experts, the US financial crisis teaches almost nothing about how to manage financial sector risk.  It neither proves nor disproves the usefulness of a highly deregulated and innovative financial system.  China´s financial sector issues are different.   China´s systematic misallocation of capital is its biggest financial problem.  China needs serious governance reform and interest rate liberalization so that capital can flow to the most dynamic parts of the economy and be made available to risk-taking entrepreneurs in a way the fosters productivity growth.  It needs capital to be correctly valued so that it is not wasted on creating overcapacity, asset market bubbles, and trophy projects, all of which detract from future consumption growth."


On a related note, this is written by advocates of creating an "infrastructure bank" - a bank, run by the government, that would supplement private credit for building out bandwidth, roads, electrical distribution, etc. This would be a massive, massive improvement over congressional appropriations, because nothing gets built that doesn't find a private backer willing to take on credit risk, filtering out pork and resulting in much more effective short and long run stimulus.
How to guarantee your luggage won't be lost or stolen: pack a starter pistol

Best time to have surgery: Morning (4x less likely to have complications in the morning than between 3-4PM)

Best time to get a human being on the phone when calling a company's customer service line: As early as possible (lowest call volume)

Best day of the week to eat dinner out: Tuesday (freshest food, no crowds)

Best day to fly: Saturday (fewer flights means fewer delays, shorter lines, less stress)

Best time to fly: Noon (varies but pilots say airport rush hours coincide with workday rush hours)

Best time to exercise: 6-8PM (body temp highest, peak time for strength and flexibility)

Best time to have sex: 10PM-1AM (skin sensitivity is highest in late evening)



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