This is certainly the most severe financial crisis in the United States since the Great Depression – and the Federal Reserve is providing money and giving liquidity to institutions that it does not supervise or regulate. However, many of such financial institutions might be insolvent.
In addition to the RTC solution created during the eighties in the USA to clean up the so-called “savings and loan associations”, one of the best historical examples of non-conventional solutions which were really able to attack successfully similar banking/financial problem situations can be found in Brazil. Yes, Brazil.
The so-called PROER was used by the Central Bank of Brazil in the nineties in order to attack directly a serious banking crisis, using of course public funds and establishing a clear division between the concept of “bad bank” and “good bank”, with the Government of course absorbing bad assets.
Another important solution (which is less well-known) is related to the Swedish Banking Crisis of the early nineties. An excellent summary of the roots and consequences and solutions for the Swedish problems can be found in the Oxford Review of Economic Policy, vol. 15, number 3, in a paper written by Peter Englund from the Stockholm School of Economics.
The Federal Reserve will be taking a wrong decision if it continues to provide liquidity to non-bank institutions without supervision. This is not a liquidity crisis, but a crisis of credit and insolvency. Perhaps Obama or McCain should hire Paul Volcker and/or the Central Bank of Brazil as advisors in order to learn some lessons and obtain some advices.
Naturally, solutions such as the RTC in the eighties in the USA or the PROER during the nineties in Brazil have fiscal implications, which mean that there is a necessary involvement of the Presidency and the Congress. Depositors and investors need protection, but not the fund managers, which took high risks looking for performance fees (a one-way speculation for them).
The fact is that there is a systemic crisis focused on the financial sector in the USA, which unfortunately will still certainly demonstrate much more losses with bad loans and assets. There is a long term crisis and any solution requires the restoration of confidence in financial assets. What is happening today in the capital markets is an authentic black-out in the financial information networks. These information networks, as pointed out by the American economist John Rutledge, suffer from time to time temporary black-outs. We are in a financial black-out. Just like electricity black-outs, such failures occur suddenly without notice. But they tend to disappear with the restoration of confidence.
It is important to emphasize that Brazil was able to face very well – since the creation of the Central Bank in 1964 – systemic banking crises which, in the case of Brazil, were fed by inflation, big devaluations and external debt problems. Just as examples: between 1974 and 1999 (25 years), some very interesting solutions were found in cases such as Banco Halles, Comind, Auxiliar, Nacional, and Banco Marka. They were correct and brilliant. It is true that many times presidents and directors of the Central Bank, which had the courage to attack frontally the threat of systemic financial crises, had to face a massacre in the press, including legal suits, but Brazil as a country in retrospect certainly owes a lot to them.
Brazil has nowadays a strengthened banking system, where banks such as Bradesco and Itau are worth in US$ market value more that big European banks and big USA banks, thanks to courageous decisions such as PROER, FCVS, as well as the so-called Marka-Fonte-Cindam case, which was transformed by the press into a “scandal”.
On the contrary, today in the USA, in contrast to 1907 or 1987 or 1997 – three difficult moments ( “the panic of 1907”, the stock market crash of 1987, and the LTCM/Russia/Thailand crisis of 1997), nobody seems to know exactly what should be done. Nobody seems to have the courage of Brazilian Central Bankers, which were criticized (and eventually indicted), but at the end of the day saved and strengthened the Brazilian banking and financial systems. And also the so-called Swedish solution (see below) is another very important “case study”.
We do not expect of course a repetition of 1929, but we fear sincerely that the USA economy might “stop” for many years, just like Japan did in the nineties.
We agree entirely with a very interesting analysis made by the American economist John Rutledge (in his blog), who argued that the existing problem with the USA economy is not getting people to spend money, but getting investors to own securities, something which could be accomplished only by giving investors better visibility over future cash flows.
According to him, recent events show that there is a fatal flaw in the way the capital markets price securities. The dominant pricing methodology – known as Modern Portfolio Theory, CAPM or Black-Scholes – assumes that markets are in equilibrium at all times. That is clearly not the case, according to Rutledge. It is the temporary breakdowns – the ones we may call blackouts – that are responsible for financial crises.
The USA economy’s real problem is not how to get consumers to spend more money – they are good at doing that. It’s how to get investors to own the stock of outstanding bonds and equities in the asset markets. The stock market and mortgage market issues are questions of visibility and valuation in the capital markets – investors sometimes do not feel able to estimate and give a value to the cash flows from existing securities. These problems can only be fixed by giving investors some comfort and visibility over those cash flows.
There is a clear confusion between a banking crisis or capital market crisis – which has to do with stocks and inventories – with flows related to the real economic activity and to GDP. The wrong leg is being operated by the doctors. At the present moment, raising interest rates – just like lowering interest rates a few months ago – could be useless and have no impact neither on real economic activity nor on inflation.
As a matter of fact, with the lack of confidence in the financial system and the black-out of the interbank market, for all practical purposes interest rates in the market are already extremely high. The best example is the market for auction-rate securities, related to municipalities and public loans.
What is happening today in capital markets and financial assets in the USA is not a GDP event – which involves basically flows of goods and services -, but a serious problem with the inventories of securities.
Very simple calculations suggest that financial securities and assets represent more than 15 times GDP in a country such as the USA.
The black-out means that investors are not willing anymore to maintain the existing stock of securities at present prices. Information networks are blocked, precisely because of the existing financial blackout.
In order to solve such problems, Brazilian experience, for example, indicates measures that have nothing to do with normal or conventional fiscal or monetary policy. As a matter of fact, Government interventions are necessary. Any economics textbook explains the meaning of “externalities” as a major argument to support Government interventions in financial markets.
The Swedish banking crisis in the early 1990s is another excellent case that should be studied by the Federal Reserve. Newly deregulated credit markets after 1985 stimulated a competitive process between financial institutions where expansion was given priority. Combined with an expansive macro policy, this contributed to an asset price boom. The subsequent crisis resulted from a highly leveraged private sector being simultaneously hit by three major exogenous events: a shift in monetary policy with an increase in pre-tax interest rates, a tax reform that increased after tax interest rates, and the European exchange rate crisis. Combined with some overinvestment in commercial property, high real interest rates contributed to breaking the boom in real estate prices and triggering a downward price spiral, resulting in bankruptcies and massive credit losses. The government rescued the banking system by issuing a general guarantee of bank obligations. The total direct cost to the taxpayer of the salvage has been estimated at around 2 per cent of GDP.
Bear Stearns was saved. However, we need to leave a question in the air: what about hedge funds? How many hedge funds exist in the USA, with leveraged positions certainly greater than 50 or even more? Non-bank financial institutions became much more important than commercial banks, particularly hedge funds and other types of investment funds, due to the freedom to leverage positions and to carry long-term risky assets practically on an overnight basis.
It seems that the USA should follow-up and study what happened in Brazil and Sweden around 15 years ago.
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