Leaving the Plaza Accord behind

Once again, Japan’s experience post-Plaza Accord has been brought up as a mistake to be avoided, against the backdrop of the escalating pressures on China to revalue the renminbi.

This time it was Chinese economist and member of the Central Bank’s monetary policy committee Li Daokui, who said last week that "China will not go down the path that Japan did and give in to foreign pressure on the yuan's exchange rate.”

I personally find the parallel misplaced and the reason is that it confuses the legitimacy of the objective (=revalue an undervalued currency to help towards the correction of global imbalances) with the (in)appropriateness of its implementation. Still, revisiting Japan’s situation during and after the 1985 Plaza Accord can offer valuable lessons for how to do things better this time round—both for China and its trading partners.

So, the mantra linking the Plaza Accord with Japan’s subsequent economic malaise goes like this: The large revaluation of the yen prompted large amounts of speculative capital inflows into Japan which, together with a loose monetary policy, fuelled an asset bubble that then burst pretty spectacularly.

In my view, the key weakness of the argument is in its presumed causality from the yen’s appreciation to Japan’s asset bubble. Of all the factors cited in the literature as contributing to the asset price boom and then bust, the yen’s move is at best an incidental one.

First of all, the rise in asset prices, notably real estate, had been building up even before the Plaza Accord. One key reason behind the increase was the aggressive growth in credit, notably to the real estate sector. This was itself prompted by a host of structural reasons, including inter alia:

The liberalization of interest rates, which, by raising deposit rates, reduced banks’ profit margins and forced them to look for higher-yielding lending opportunities; the opening up of capital market access to corporates, which shifted part of the corporate funding away from the banks and towards the capital markets—this pushed banks to look for new clients to lend, often with higher risk characteristics; and a distorting tax regime governing the real estate sector, which encouraged the holding onto real estate assets, thus restricting supply, while demand was rising.

If there is a lesson for China here, it has little to do with exchange rate policy. Instead, it is that preventing the build-up of bubbles requires a robust regulatory framework for the financial sector—one that penalizes excessive risk-taking and dampens the procyclicality of credit (a lesson that we have come to learn yet again in the aftermath of the subprime debacle).

The second lesson from Japan’s experience has to do with the role of monetary policy in contributing to the boom and bust. And here is where the Plaza Accord deserves criticism—though not for its prescription on exchange rates!

You see, the agreement was not *just* about foreign exchange intervention to realign the nominal exchange rates; it also prescribed global coordination of macroconomic policies to correct the global BoP imbalances. This latter component was a key factor behind the Bank of Japan (BoJ)’s loosening of monetary policy during 1986-87.

As three Japanese academics document here, the BoJ had expressed concern early on about the easy money, the concomitant speculative activity in the real estate and stock markets, and the dangers of a subsequent debt deflation. However, the BoJ proceeded with rate cuts, partly in the face of pressures by its trading partners to stimulate domestic demand (these pressures were made explicit in the Louvre Accord in February 1987, under which Japan pledged another 50bp rate cut in its policy rate).

One can debate of course how big a role monetary policy in itself can play in fuelling asset bubbles of the scale experienced in Japan in the late 1980s. Indeed, those who object to the premise will find a staunch ally in Ben Bernanke! But my main criticism here is that, by calling for stimulative monetary and fiscal policies, Japan’s trading partners confused the cyclical from the structural causes of the global imbalances. The result was a monetary stance that was too loose for Japan; and the diversion of attention away from corrective measures that had to be taken by the likes of the United States.

The situation is somewhat different at the current juncture with China. First, few people dispute that the key reasons behind China’s external surpluses are structural—and, therefore, nobody is really asking China to take inappropriately stimulative measures to increase domestic demand. In the same vein, there is no doubt that structural reforms to rebalance growth domestic demand and, notably, private consumption, would be welcome by the global community.

But this is no reason to dismiss the exchange rate revaluation as *one* corrective tool: First, as I argued here, China has yet to bear the brunt of the (cyclical) correction of global imbalances since the onset of the financial crisis: Even as its own trade surplus has shrunk, the US trade deficit with China has barely moved in US GDP terms. Most of the US adjustment has been borne by other countries.

Importantly, a large exchange rate undervaluation in a country as large as China contributes to the misallocation of global resources—e.g. by prolonging the survival of inefficient companies/exporters in China and/or by encouraging the outsourcing of business to China thanks to an artificially low cost structure.

Bottom line, evoking Japan’s experience under the Plaza Accord as a reason to rebuff pressures to revalue the renminbi is misplaced, if not disingenuous. While nobody can dispute the need for a score of structural measures to fortify the financial sector and contain the formation of bubbles in China, maintaining an undervalued exchange rate can only serve mercantilistic objectives and/or protecting certain industries at the expense of a balanced, efficient and fair allocation of global resources.

Mom, free-market and apple-pie

July’s housing bill was received with a round of applause by politicians and analysts alike. A bill for “regular folk” some suggested, bringing together a creative mix of measures to salvage home ownership and the American Dream.

Sure enough, the bill seemed to have something for everyone:
- A rescue plan for Fannie and Freddie and, by extension, the mortgage market as we know it and, ultimately, house prices.
- Up to $300-billion worth of government guarantees to help ill-fated borrowers negotiate their way out of foreclosure.
- $4 billion of grants to local governments to buy and rehabilitate foreclosed properties.
- Additional tax deductions for homeowners who (poor guys) are being traumatized by the decline in their home equity… etc etc.

“What about me?!” rants Joe Schmoe. That’s my neighbor from the skyscraper next door, and a fellow “regular” at our local Greek deli. A middle-of-the-road working professional in his mid-thirties, Schmoe seems to share my fondness for fried calamari on a Sunday night. Importantly, Schmoe is a renter (and aspiring homeowner) and, as such, represents one-third of America’s households.

For the Schmoes of this world the housing bill is anathema, and I quickly get the message as my neighbor’s fiery gestures end up overturning our shared Athenian tzatziki.

“Poor homeowners??” It is by now consensus that house prices overshot in recent years to levels way above what is justified by “fundamentals.” Indeed, a recent study by the IMF (see Chapter I here) reaffirms the point using two different methodologies: The first compares current house prices with what prices would have been, had they been driven solely by fundamental factors such as disposable income, mortgage rates, unemployment, construction costs or household size. The second method estimates a long-run relation between house prices, rents and interest rates and uses that to infer a “fair” price for house prices today, given today’s rents and interest rates. Both approaches conclude that, despite the recent price declines, American homes remain overvalued by more than 10 percent.

So those poor homeowners can’t be that poor after all. Apart from those who bought a home after mid-2006 (i.e. near or at the market peak), the rest are simply seeing a reduction in wealth that, arguably, came unduly fast. Any measures to arrest the decline in house prices would just prolong this overvaluation, benefiting homeowners who are sitting on (and some splurging with) an artificial wealth and hurting the Schmoes who have been waiting for the (free?) market to correct its own excesses.

Savers’ plight: Then we’ve had the credit crunch, distress in the financial system, the collapse of Bear Stearns, runs on anything—from hedge-funds to regional banks. So Ben rushes to cut interest rates by 3.25 percentage points to save America from slipping into a fat tail.

Schmoe is not happy! He had been prudently saving money to buy a home once his income stabilized and house prices returned to more sane levels. But with Fed policy rates down 325 basis points, savings rates are also down—Schmoe now earns 1.50 percentage points lower interest on his one-year CDs than a year ago.

This is bad enough... with inflation this year turning our higher than expected, his savings have been eroded in “real” (purchasing power) terms. But it gets worse. The Fed’s cuts have actually failed to translate into lower borrowing rates for aspiring home-buyers, as stress in the financial sector persists and banks are tightening their lending standards. For example, rates on a 30-year fixed mortgage have increased by more than 50 basis points since a year ago. So the Schmoes, savers in general, and even potential “refinancers” are being “treated” with a double whammy when it comes to protecting (or investing) their savings.

Paying the bill: Then there is the bill… I mean, the bill of the housing bill, which we will all be invited to pay, homeowners or not. Only that, unlike homeowners, who at least benefit from tax breaks in the form of mortgage-interest and real-estate-tax deductions, for Schmoe-the-renter the check will be especially sore. True, the housing bill contains “tax credits” for first-time buyers, so he could rush to claim his share of the pie? Well yes, although the “credit” is really an (interest-free) loan to be paid back over 15 years. In addition, it’s phased out for those earning above $75,000 and, capped at $7,500, is just a fraction of the median home price ($214,000), let alone the insane sums Schmoe needs these days to buy a hole-of-an-apartment in New York.

The bill could be large. The Joint Tax Committee estimated the cost of the bill’s tax provisions for multi-family and low-income housing at almost $16 billion over 2008-09, with (only partial) “payback” period after than. On top of that there are contingent payments associated with the government’s guarantees on up to $300 billion worth of mortgage loans. Some might sigh with relief reading the Congressional Budget Office’s (CBO) estimates that “only” around $68 billion of these guarantees may end up being extended due to the strict eligibility requirements and conditions. But Schmoe is losing faith...

Taking out the bazooka: …Especially as he watched Fannie and Freddie plunge deeper into crisis-territory last week. You see, Schmoe had trusted Hank Paulson and his “bazooka” rationale for rushing the bill through Congress: “If you've got a bazooka in your pocket, you may not have to take it out,” Hank eloquently argued. In other words, the bill was (hoped) to act as a “sell-off deterrent”—dissuade investors from taking their money out of the GSEs by offering the possibility of a government bailout. A botched hope, it turns out, as Fannie and Freddie’s stocks continued to dive, raising the chances of an actual Treasury bailout.

How big a bailout? Even the CBO shrank from revealing the ugly truth. In its letter to Congress, the CBO said the expected value of government intervention was $25 billion, reflecting a range of possible outcomes (from zero up to an unreported amount), each with different probabilities. The unreported amount would likely exceed $100 billion, which the CBO's worst-case-scenario for credit losses by the GSEs. In that scenario, the government would need to cover not only the $100 billion, but whatever more it took to restore investors’ confidence in Fannie and Freddie’s capital adequacy.

Back to the American dream: By now, Schmoe sounds like he's craving for desert: “Whatever happened to America’s mom, free-market and apple pie?”

“This housing bill is a reward for the reckless, the greedy, the uninformed—all those who indulged themselves ‘to debt’, blowing up house prices, inflating our trade deficit and crushing the dollar to its feet. All in the name of home-ownership! If you want to promote home-ownership, allow house prices to return to “sensible” levels… let the market find its bottom, correct its excesses, and learn better in the process.”

Schmoe is fuming… tzatziki all-over, fingers greasy, table in a mess. A moment when the invisible hand would indeed come in handy!


Glossary: free-market, invisible hand, long-run equilibrium value, bazooka, apple pie.

Readings: How to Shore Up America's Crumbling Housing Market

“Double, double toil and trouble…

… Fire burn, and cauldron bubble”
The three witches in Macbeth, by William Shakespeare.

At my first job, more than a decade ago, I was given the nickname “bubble.” The term was coined by a British colleague, the result of a (rather esoteric) line of thinking on his part, having to do, not with Shakespeare, but with Cockney rhyming slang. I confess I didn’t find the name particularly flattering—I mean, “Chevelle” is far cooler! Yet, despite my protests, it was not long before I caught myself raising my head automatically upon mention of the word “bubble,” no matter the context!

So you can imagine the headaches I’ve developed recently, as the housing bubble is bursting here in America with a deafening “Bang!” Policy makers have been scrambling their heads, trying to devise ways to deal with the fact that some bubbles are less... “fun” that others!

The crux of the debate was eloquently put by Fed Governor Frederic Mishkin last week. Here is my paraphrased version:

Are some bubbles more dangerous than others? What should we do about them? Sit and watch, or take action? And, when it comes to action, what should that involve? Interest rates or regulation?

From bubble baths to NASDAQ: Some basic truths first: Bubbles can be quite inebriating—be it bubble gums, bubble baths, champagne bubbles or sky-rocketing stock prices at NASDAQ. As such, they also tend to be extremely inviting: Nobody wants to feel left out, so everyone floods in, the party gets crowded, and stock prices rise exponentially, reaching levels that cannot be justified by “fundamentals” (like corporate profitability, economic growth, etc). Meanwhile, if you are one of these “sober” voices calling for caution, the most likely response you’re going to get is "Have another glass!"

One day, Bang!! What next?

Well, it depends on the bubble. Bubble gums are pretty safe. Ditto for champagne bubbles: No matter how wasted you get, somehow, someway you’ll make it home. Stock market bubbles are a touch messier: The BANG will be usually accompanied by an impressive destruction of wealth, as the prices of your (and many others’) stocks decline calamitously.

Still, not that disastrous: You may have lost money, a LOT of money, but you still have your home, your car, your wife and kids. Your job too… if you’re lucky. And in the process, you may have even learnt a lesson: Next time, you’ll look for more “sensible” companies to put your savings at work, rather than investing in baloney start-ups with as inventive business ideas as online recycling of pet poo.

So these are the kind of bubbles it’s ok to sit and watch. But could there be bubbles that are more catastrophic?

Feedback loops: That’s what the Fed seems to think. Accordingly, bubbles that are fuelled by more and more borrowing can be particularly dangerous: Once they burst, they cause severe damage, not only to the “drunk ones” but to the financial system as a whole. Which in turn means that you and me, the “sober” ones who stayed away from the party, will also pay a big price in the form of slower economic growth, job losses, expensive access to credit, etc etc.

The recent housing bubble is a case in point. You had more and more people buying homes, as low interest rates and financial innovation (like the originate-to-distribute model) spurred growth in the issuance of mortgages. Home prices went up. Banks became complacent and loosened their credit standards: With rising home prices, they could always foreclose the property and get their money back if a borrower defaulted. So more mortgages were extended. Prices went even higher… more borrowing ensued… A vicious “feedback loop” that (next time!) should be stopped. But how?

Not me! That’s certainly what former Fed Chairman Alan Greenspan would have said. Ben seems to share that view: It’s not up to monetary policy (interest rates, basically) to correct the situation. And this for a number of reasons:

TiVo vs. TiVo Inc.: First, the objective of monetary policy is to promote a healthy pace of economic growth while maintaining price stability. When it comes to “price stability,” what the Fed cares about is consumer prices (e.g. the prices of cars or TiVos) not asset prices (e.g. the prices of homes or tech stocks).

Here is why: Asset prices send a signal to investors about the profitability of putting money into a particular business venture. They are therefore critical in channeling capital to (what are perceived as) productive economic sectors (be it technology companies or real estate). Any government interference in the form of, say, setting price “ceilings” on specific assets would distort the resource allocation process, compromising economic progress and efficiency.

Why me?! A second reason is that a bubble may be occurring in a particular class of assets—say housing—rather than in every asset. Therefore, by raising interest rates to stop that bubble from inflating further, the Fed will be hurting at the same time the entire economy. And why should I, the tomato paste producer, be paying higher interest rates because you, the online poo-recycler, are putting more and more money to more garbage “tech” ventures?

Is that a bubble? But there’s another problem: It’s actually not that easy to call a bubble a “bubble.” A bubble occurs when the price of an asset rises enough to deviate from a “fair” price that is based on “fundamentals.” And, as many will attest, it’s not easy to determine that “fair price.” Besides, if the Fed could know that price, why can’t investors? They’re both as smart and have access to the same information, right?

Regulate: With monetary policy “out,” the Fed seems inclined to pitch for regulation as the instrument for dealing with bubbles—the dangerous ones, that is. The objective would be to avoid those feedback loops between credit growth and asset price bubbles: For example, by re-linking the incentives for issuing mortgages to the quality of the loans rather than the volume; by re-establishing proper checks and balances on borrowers and their ability to pay; by improving the performance of credit rating agencies.

Some also are talking about the Fed assuming new powers that would allow it to influence the behavior of financial institutions if this is deemed to lead to systemic risks. Others have proposed making banks’ capital requirements “anti-cyclical”: That is, during good times, banks would be required to increase the “cushions” of capital they are required to hold, making it more expensive for them to lend more, and thus curbing their overall lending.

As you can see, ideas abound, and not all are flawless. But the environment is ripe, the frustration real and the chatter louder, so expect to see regulatory action sooner rather than later.

Meanwhile, we can all continue our detoxicating period with another glass of… water. Bubbly, of course!


Glossary: asset prices, consumer prices, bubbles, fundamentals, capital requirements, cockney slang, Macbeth.

Hit by a fat tail...

It’s 10am, your rottweiler has just chewed your Italian leather boots, your wife has burnt your pancakes and your mistress is on the phone proclaiming that “it’s over because, really, you’re pretty lousy in bed.” Oh yeah, and while you’re at it, your broker is leaving you a message that the stock market is crashing and you’ve lost a third of your savings. A bad hair day? No, my friend. You’re likely living in a fat tail!...

…In a manner of speaking! Economists talk about fat tails when they want to refer to the probability that extreme events such as the above occur in a much higher frequency than you would regard as "normal."

So why tails? And why fat?!

It all began with what we call a probability distribution. Think of each day of your life as a dot under a bell-shaped curve: Most of the dots are concentrated around the middle, in the bulge of the bell: Days of medium pain and medium pleasure; boots are shiny, pancakes edible and mistress satisfied (at least that’s what you think!)

But then you get those few days of tremendous joy or extreme misery. These will be situated within the small little corners at the right and left of the bell—the “tails”. The fewer the extreme days, the thinner the tails. Now, if you are an extreme type, your life bell will look somewhat different: A thinner bulge in the middle (with fewer average days) and, yes, you guessed it, “fat tails!”

Roaming around the various salons these days, you’ll notice much of the party chatter being about tails; tails behaving badly. In fact, it’s not just party chatter. Some economists are losing sleep over this, and first and foremost Ben Bernanke. And given the bashing and teasing he has received for his recent emergency cut by numerous commentators, myself included, I though we owe it to Ben to at least present his side of the story.. out of respect for his lack of sleep as well as his remarkable contribution to the body of academic literature in the field.

So there it goes: “I’m having a nightmare here!…” Ben is pleading. “I am dreaming I’m inside a bell-shaped universe and the tails are suddenly fat! Wait.. it gets worse: One of them, that nasty left one, is much fatter than the right one. Yes, not only are things more likely to get extreme, but it’s not going to be that you’ll win the lottery. Instead, you’re going to lose your job, your shares will crumple, the value of your home will collapse and you might even get a run on your bank that will see your deposits evaporate.”

“So I feel I should take action. No, it’s not because I care about the stock markets. It’s about that thing I am allowed to care about: GROWTH!

“You know, back in the ‘80s I wrote a paper where I suggested that sharp declines in the prices of shares, houses, etc can amplify and prolong a downturn in economic growth. This is how it works: For banks to lend you money, they need to feel comfortable they will get paid back. So they will ask you for a collateral—your home, say. But if the value of your home drops below the amount you borrowed, banks will feel uneasy: If you were to default, they could take your home and sell it but they would not get all their money back. And uneasy translates in lower lending.”

“So see what happens: The economy slows, jobs are lost, home prices go down, banks cut back their lending, new business ideas cannot get financed, the economy slows further, more jobs are lost, etc etc. Combine that with a drop in share prices, and it gets even worse. A downward spiral to misery. I called that the ”financial accelerator” at the time. Pretty scientific, huh?"

“So as I was saying before, I’m taking action. Timely, decisive and flexible action. I’m cutting rates in a drastic fashion, and pampering the markets I’ll be there for them.. and pray for the best! Better safe than sorry.”

Hmmm.. “safe”? Not exactly, there are always risks. First, you have the risk of perpetuating complacency in the markets by fomenting moral hazard. Second, you have the risk of undermining that second objective that Ben cares about: Inflation.

And then, you also have the question of symmertry in the line of reasoning itself: Surely, the financial accelerator works to amplify the impact of market upturns too in ways that can be undesirable: Bank lending becomes excessive, the price of risk-taking drops to absurd levels, markets become “irrationally exuberant.” All that breeding ground for a big fat crash. (Sounds familiar?) Isn’t there scope, therefore, for timely, decisive and flexible action in such cases?

Well, I’ll chew my Italian leather boots the day Bernanke’s Fed comes out and says: “Following days of market euphoria and loose credit conditions, the Federal Open Market Committee decided today to raise its target for the federal funds rate by 75bps […] and stands ready to take further action if such conditions continue.”

Glossary: fat tails, well-behaved tails, probability distribution, collateral, financial accelerator, rottweiler.

And if you want to read further:
Fed’s rate cut marks an end to gradualism (Financial Times)

Bernanke’s Bounty

Federal Reserve Bank of New York Governor Frederic Mishkin on Monetary Policy Flexibility, Risk Management, and Financial Disruptions

Ben dials 911

Today was big. Bigger than 9/11. No, I’m not being unpatriotic. It’s just that this is what Ben Bernanke, the Fed’s Chairman, wants us to believe.

I went to the office early in the morning, admittedly with (more than) a whiff of nervousness about how the US markets will open after yesterday’s stock-market carnage in Asia and Europe. And then the “bomb” fell: In an emergency move, the Fed cut the federal funds rate to 3.50% from 4.25%--a “75 basis point cut”, if you want to sound like a pro. Wow! The last time the Fed cut rates in an emergency meeting was six days after the 9/11 terrorist attacks. I mean, we already knew that the economy is in a mess, but still, that’s big!

Indeed, the Fed justified its move by citing the difficult borrowing conditions for businesses and households, the deterioration in the housing market and the recent poor employment data. But really, could Ms. Economy not wait for another week, on January 29th, when the Fed was scheduled to meet anyway and get its chance to act in as drastic a fashion as needed? Why the code red? And can someone tell Ben to stop acting like a panicked rookie?

I don’t want to downplay the bloodbath that we might have seen in the markets today in the absence of the Fed’s move. I own stocks myself and, yes, it hurts! But since when did the Fed add to its dual mandate (of price stability and full employment) a third one, that of spoiling the markets? I mean, let’s say there is value in some ad hoc salvaging of the markets from their own “irrational” behavior; but then why not try to also rein them in before their “irrationality” creates all sorts of bubbles and mispricings? Yeah yeah, I’ve heard it before, “you only know it’s a bubble once it bursts.” But then I challenge you to a duel over the identification of a “market correction” versus a “market collapse.”

More importantly: Will the cut work?

As far as the “real” economy is concerned, the Fed’s cut undeniably provides a good deal of help—especially since may be more to come. Financing conditions become easier for businesses, banks and households, and the housing market, which has been the source of the mess, will benefit from lower interest rates for new mortgages (or the refinancing of existing mortgages).

But when it comes to assuaging the markets, that’s a bit different. The root of the market meltdown continues to be, largely, uncertainty over the health of major financial institutions, from Citigroup to Merrill Lynch to Bank of America, in face of losses from investments linked to the subprime mortgage sector. The trigger for the most recent dive was two pieces of bad news about two sellers of insurance against potential default on some debt instruments: ACA Capital and AMBAC. The former was near collapse and the latter was downgraded (see here for explanation of "downgrade"), and this led to fears that the price of the debt instruments these guys insure will go into a freefall. Now guess who has invested in these instruments? The Merrill Lynches and Citigroups of this world, so the news on ACA & Co. foreshadowed even more losses for these banks and more cuts in lending!

It’s really hard to see how a Fed interest rate cut will help resolve the problem of lack of information on the potential size of banks’ losses, or the uncertainty over what is the “fair” price for all these exotic instruments that are burdening banks’ portfolios and are partly preventing them from lending more. That’s why the market impact of the Fed’s cut is probably at best temporary.

So fasten your seatbelts. And Ben, we liked you more in your cool. At least I did!

Glossary: The Fed, federal funds rate, bubbles, corrections, basis point (pronounced ”bip”), Uncle Ben