Willem Buiter is on a roll

January 25, 2008 by E. Cartman

Among uber-academia, I am pretty sure Willem Buiter is the only man of his degree of stature or higher who gives the Bernanke-Mishkin Fed anything near the level of scorn and contempt it deserves. I try not to be a promiscuously copy-pasting linkbot, but Willem Buiter is hands down the best credentialed commentator I have come across.

Don’t worry, be happy despite monolines and Société Générale

Even with a few days worth of hindsight, the Fed’s out-of-sequence, out-of-hours 75 basis points cut in the target for the Federal Funds rate continues to look extraordinary and deeply misguided. Indeed, it looks less and less like a decisive pre-emptive move in response to unexpected bad news designed to meet the Fed’s triple mandate of maximum employment, stable prices and moderate long-term interest rates, than a knee-jerk panic reaction to a global stock market collapse. Did the sharp global decline in stock values at the beginning of this week reflect a rational re-assessment of fundamentals? The only two candidate explanations I have heard are (a) that the collapse was probably triggered by concerns about the financial viability of the monolines and (b) that it was intensified by the unwinding by SocGen of the long equity positions taken by its employee of the year (not!). I find neither explanation convincing. …

Monolines

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Monolines are few in number and small. They don’t have a lot of capital. It seems unlikely that, in an even vaguely rational world, their existence would make a huge different to the performance of the credit markets and, indirectly, the equity markets. It is clear that, while they may well offer credible protection against idiosyncratic default risk of individual borrowers, they will offer no protection against a significant economy-wide increase in defaults, such as may be associated with a recession. Monolines are unbelievably leveraged: last year the value of their outstanding guarantees was 150 times capital, with the notional value of the insured assets at around $ 3.3 trillion and capital of between $20 billion and $25 bn.

It does not take a wildly implausible increase in the level of the average default rate to wipe out this capital. I don’t understand a business model for default risk insurance which implies that your capital will be wiped out if less than 0.7 percent of your insured assets go belly-up. The efforts by New York state’s Insurance Superintendent to get a posse of banks to put up between $ 5.0 bn and $15.0 billion to shore up the capital of the monolines, after one of the largest two (AMBAC) lost its AAA rating, seem modest compared to reasonable estimates of the expected losses of the monoline industry. Perhaps the decimal point should be moved one place to the right?

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Société Générale

The fraud at Société Générale, resulting in a € 5bn loss will provide bloggers and columnists everywhere with material for weeks to come. It raises serious issues for regulators and supervisors of banks and other financial institutions. But it is not a macroeconomically significant event. Like all theft, the fraud itself merely redistributed wealth, without any obvious effects on aggregate demand. To make a loss of €5bn, there probably was an exposure of between €50 and €70bn. Société Générale closed all these positions in a hurry starting Monday. This may have contributed to the stock market decline in Europe, but the rout was already under way in Europe (and earlier in Asia), before Société Générale did its bit for the bears. I assume the Fed must have been informed of the Société Générale debacle by the French regulator (the Banque de France) before it decided on its rate cut (Monday evening US time).

The stock market sometimes loses its nerve. Left to its own devices, it will recover it. There is no monetary policy mandate to protect those who lose their nerve against those who don’t. So it looks as though the Fed, like the stock market, simply lost its nerve.

As an aside, I am usually a believer in the screw-up theory of history rather than the conspiracy theory of history, but in the case of Société Générale I am not so sure. How could one man, a junior trader, even if he is a wizz at Solitaire, carry a € 50 billion to € 70 billion position day after day without anyone else noticing? He is supposed to have been long equity. That cannot have been a long outright position, because this would have been noticed in the cash markets. It cannot have been in the equity futures markets either, because that requires margin payments whenever stocks fall. The perp would have been caught a long time ago. So how did he do it? Did he sell equity puts? Could he have done this on his own? Unlikely, I would say. He has also, conveniently, disappeared. If he is found hanging from a bridge somewhere, my suspicions that there is more to this than has thus far met the eye will have been confirmed.

Conclusion

The stock market giveth - the stock market taketh away; and then the stock market giveth again etc. Most of the high frequency movement in stock prices is fluff – noise that policy makers ought to ignore.

Many commentators talk as if a recession in the US is a done deal, with a recession in the UK not far behind and significant weakening in Euroland coming up fast in the outside lane. I am not so sure.

A recession in the US is possible, but not in my view the most likely outcome. Employment appears to be holding up better than would be consistent with the economy already being in recession or about to enter it. Clearly, the housing sector and the financial sector in the US have over-expanded in the latest credit boom and will have to contract painfully. Profits, capital and employment in these two sectors will all fall. But outside these two sectors there has not been any significant degree of excessive capital formation in the US economy. The same holds for the UK. In Euroland the situation is even better, because there the housing sector has only expanded excessively in a few cases (Spain and Ireland), while the financial sector appears to have expanded excessively only in the Netherlands, Germany, Spain and Ireland.

The contraction of the financial sector will have repercussions for the non-financial economy, especially for the household sector, which is more highly leveraged than the non-financial corporate sector. But as yet there is no sign of a major across-the-board decline in activity even in the US, let alone in the UK and in Euroland.

Both the housing sector and the financial sector are among the most vocal sectors in the economy. The amount of attention paid to these sectors by politicians, policy makers and the media is quite disproportionate, when compared to their fundamental economic significance. When regulatory capture extends to the central bank, the quality of monetary policy making is bound to suffer. We have seen this in the US since Greenspan took over from Volcker as Chairman of the Fed. And it continues today.

We will see a slowdown in global growth, with the most severe slowdown likely in the US and the UK. But even there I don’t understand how those yielding the R-word can be as confident as they pretend to be.

I don’t agree with all of it. I think a moderate recession is the most likely outcome. But he’s much closer to the mark than pretty much anybody else, certainly on this side of the pond.

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