WSJ on Aussie Mac

I’ve been a little busy so haven’t had time to comment on the Government’s ramping up of its residential mortgage-backed securities intervention of last week. Chris Joye has done an excellent job of laying out the pros and cons of that intervention. The pro being that it is a necessary intervention especially given the Governments other guarantees in this sector and the cons being that it is hardly a long-term solution.

Anyway, four days after the Government’s moved, the Wall Street Journal finally popped its head up to condemn it. This is the speed that you will be paying good money for soon. Their contention is that the Government’s intervention looked like “Aussie Mac in the making” and that if you think about “Mac” then you are thinking Fannie and Freddie and that was terrible so the Australian Government learned nothing. Let me just spell out that an intervention into the RMBS market by a branch of the Treasury is not the same as a privatised and obscurely guaranteed and largely unregulated couple of firms dominating the market. The fact that the Government is not doing that and moving more cautiously is an indicator that it is learned from the spectacular US regulatory errors here. Indeed, it may look further north to Canada to see how a “Mac” institution should really work (for some references see here).

But in reading the WSJ article, there is a derisive sense against securitisation as if no one sensible does that anymore. I don’t have the numbers but it was my impression that most new mortgages in US are still securitised and I think there is underlying government backing there. If someone has those numbers, please share.

An expanded version of this post appeared in Crikey today (over the fold). Continue reading “WSJ on Aussie Mac”

Doubleplus Good Financespeak

Has anyone noticed how the vocablary of the finance industry is heavily laden with moral overtones?

[DDET Read More]

Consider the following list of financial terms and the images they conjure: `assurance’, `bond’, `credit’, `consolidation’, `equity’, `interest’, ‘mutual’, ‘obligation’, `redemption’, `reconciliation’, ‘security’, `trust’, ‘venture’. I wonder how many of these terms have their origins in the Protestant business philisophy of the nineteenth century – that wealthiness is next to godliness.

Even the trashy housing loans that got us into this mess are called “sub-prime”, which to me sounds like a cut of beef only slightly more chewy than eye fillet. “Lambs to the slaughter” might have been a more honest marketing strategy.

And my favourite bit of financial jargon is ‘efficient market hypothesis’ as Doublespeak for complete bloody randomness. ?


Letter in Crikey

I have an opinion piece in Crikey today (over the fold) on that letter mainly trying to talk about things other than the ‘Peoples’ Bank,’ a term that is a media invention today. Of course, the title of the Crikey piece that they substituted in appears contrary to what I was trying to do (Sigh!). That said, Bernard Keane in Crikey today does an excellent job of accurately reporting what we were trying to do in the letter.

[DDET Read the article]

“Gans: Why the People’s Bank makes good sense”

Crikey, 8 July 2009.

If there is one thing Australian governments have been good at over the past three decades, it is periodically reviewing the banking system and its regulation. Starting with Campbell in 1981 and then Wallis in 1996, governments have found that the best way to consider banking policy is to move it above the political fray, take its time, look at all parts and independently charge a panel with reviewing the state of affairs and providing clear and evidence-based recommendations.

In an open letter today, six economists (including myself) making the case for another similar inquiry to take place over the next year or so. In the letter we note that the Australian financial system has weathered the global storm relatively well but at the same time a significant and often radical set of policies have been put in place. ACTU president, Sharon Burrow, called many of these policies necessary “band aids.” At the same time, however, it is believed that those policies while shoring up our major banks have disrupted the smooth workings of the financial system. Right now, that isn’t a problem but into the future as we come out of this crisis the costs of those might be felt.

This is not simply a timely review but a necessary one. Economists have come to realise the gaps in their knowledge of how regulation performs and what the best institutions are for on-going government intervention in the financial sector. The Prime Minister is well aware of these as he articulated in his much talked about essay for The Monthly. For these reasons, it is important to step-back and assess the new knowledge gained here and around the world and consider a greenfields approach to our set of financial regulations.

It is interesting that the proposal, floated although not necessarily endorsed in the letter, that a government-owned institution might have a competitive and stabilising role was picked up so strongly in the media. That policy likely has costs and benefits and only further investigation will determine its appropriateness. The media attention surrounding it only adds grist to the mill that considered policy evaluation is necessary in this sector. Indeed, it is in the major banks’ interest to get behind a new independent inquiry lest policies directed towards them continue to be enacted on the fly or in the midst of some new political storm in relation to bank profits.

Our goal here is to decouple of review cycle from the electoral cycle for banking. That is surely something many interested groups can support.

Joshua Gans is an economics professor at Melbourne Business School. The open letter can be viewed here:


Macroeconomics in Online Opinion

It is one of those days. I wrote an article for Online Opinion on the GFC a week or so ago. It appeared today and is reproduced below.

[DDET Read the article]

The crisis and the textbooks

Joshua Gans, Online Opinion, 8th July 2009.

In August, 2008, a month before the Global Financial Crisis hit with unmistakable impact, I received the galleys for the 4th edition of my textbook, Principles of Economics. It is the adaptation of Greg Mankiw’s leading US text (co-written with Stephen King and Robin Stonecash). The edition had changed only a little from the one three years earlier. Perhaps the most significant addition was an extended discussion of climate change policy but also the juicier examples coming from the Freakonomics-like microeconomic research that had so captured popular enjoyment of economics. By the time the text was finally published, the GFC was among us and it was hard to imagine how this could not be the central part of macroeconomic discussion, let alone be absent from this most recent of writings.

In many respects, this anecdote is as much about the lags in traditional publishing as it is about economics being somehow off-base. But it is also true that the speed with which the crisis developed from something familiar to something scarily unfamiliar was striking. How could it not change the way economics is taught?

Fast forward just a few more months to the present and my concerns that the crisis was not front and centre in the book have been allayed. This is not to say it will not feature next time around, it is that it will impact on 5 per cent rather than 50 per cent of your average first year economics class.

My reasoning for this is quite straightforward. Macroeconomics is a discipline that deals with the movements of aggregates. There are two things that drive these:

First, there are accounting identities such as how the components of national expenditures must sum to the level of production or how the capital account balance must offset the current account. These are immutable and do not change – crisis or no crisis.

Second, there are behavioural relationships. These describe how broad sets of individuals make decisions and how they interact with one another. Being behavioural, these are hardly immutable and what is more, we do not know as much as we would like to know about them.

To take an example: the notion that consumption rises with current income. This assumption started with Keynes and was critical in understanding how actions that might stimulate income (such as a tax rebate or a handout) might lead to higher consumption and stimulate private activity. The rate at which this occurs drives the all important multiplier effect. However, for the better part of half a century, economists have noted that if you give someone $900 extra today, this does not change their lifetime income very much. So even if you happen to spend 80 per cent of your income, you might save more of that $900 than is your usual pattern. And if that occurs, so goes the multiplier.

So there is a debate about these measures. And in the textbook, it turns out that the precise relationship likely hinges upon liquidity. After all, you can manage or smooth your income over time quite easily if you can readily borrow during downtimes and save during uptimes. But take away a functioning banking system and that assumption does not necessarily hold. In that situation, interest rates may drop during downtimes but borrowing doesn’t occur. Hand someone some money then and it may well be spent.

What recent events have reinforced to economists is that there are three kinds of macroeconomics. First, there is the long-run, where if you wait, the cycle does not matter and you want to have your house in order, so as to grow in a sustainable fashion. Second, there is the short-run, where fluctuations do occur and government interventions such as keeping the money supply stable and allowing fiscal policy to move with the ebb and tide of the economy, smoothing the bumps.

But, finally, there is a liquidity crisis, where the financial sector stops working for a time and so forestalling crisis or reducing its effects requires active government intervention and management. It is scary because there is little science to this. And it is worrisome because there is an extent to which those actions may incur a debt of their own and slow recovery back to normalcy.

In the US, Europe and Japan, there is a liquidity crisis (for Japan it is their second in two decades). In Australia, for reasons that will be debated for years, we do not have that same crisis and are instead in the macroeconomics of the short-run. But even there with the storm coming over the horizon our policy-makers switched to a degree of crisis macroeconomic management with a pre-emptive stimulus package. There has been criticism that such measures were not necessary but it is equally possible that such measures did their job as intended.

The schism in modern macroeconomics between its three types is something that textbooks partition around but the current crisis has demonstrated that such compartmentalisation is inadequate to the task. Somehow, we need indicators as to whether we are moving from short-run to crisis mode and a way of agreeing upon a course of action for the latter. The last time this occurred globally, governments reacted very differently to the way they have now. Maybe not in the next edition but in future editions we will have learned enough about what worked given that massive bet to write a better textbook.


Call for Financial System Inquiry

Please find over the fold an open letter authored by myself, Nicholas Gruen, Christoper Joye, Stephen King, John Quiggin and Sam Wylie calling from a comprehensive inquiry into the financial system (published today in The Age). It is self-explanatory and was distributed widely yesterday.

[Update: Lots of press coverage including The Age, Sydney Morning Herald and Business Spectator. I guess this is what makes a front page Wednesday story.]

[DDET Read the letter]

  Australia Needs a Comprehensive Financial System Inquiry

Joshua Gans, Nicholas Gruen, Christopher Joye,
Stephen King, John Quiggin and Sam Wylie


Ever since the severe market failures in Australia’s securitisation industry were identified in 2008, we have been concerned that these problems were partly attributable to more fundamental flaws in Australia’s ageing regulatory architecture and the inadequately defined role of government in dealing with such crises.


The shortcomings within our governance system have been exacerbated by the relentless changes that have occurred in financial markets since the essential elements of our regulatory infrastructure were put in place decades ago. One example of this is the 1996 Wallis Inquiry’s rejection of the use of deposit guarantees, which have been critical tools for maintaining stability during the current crisis. Following the lessons that have been learned during the global financial crisis, and the 12 years that have elapsed since the last such exercise, we believe that a broad-based inquiry into the integrity of Australia’s financial system is now warranted.


While the $40-50 billion per annum residential mortgage-backed securities (RMBS) market supplied the funding for up to a quarter of all Australian home loans it did so with little-to-no government oversight or support. The growing depth and liquidity of this market enabled the emergence of significant alternatives to the major banks in the form of empowered regional banks and building societies, and smaller non-bank lenders. When this market disappeared due to an entirely external shock—the US sub-prime crisis—many of these institutions were brought to the brink of collapse and forced to withdraw from lending altogether or merge with competitors. At least one smaller Australian bank would likely have failed had it not done so.


The biggest beneficiaries of this chaos have been the four major banks that receive the most favourable regulatory treatment under the existing system, which was not conceived with many of their smaller rivals, and the new markets that they rely on, in mind. Yet the forced ‘reintermediation’ of the major banks into the residential lending arena has had other unintended effects, with the pressure placed on their balance-sheets in turn compelling them to ration credit to the higher risk small business, corporate, and commercial property sectors.


We are still in the midst of understanding the consequences of the global financial crisis and the actions of governments (including Australia’s) in response to it. Importantly, it remains uncertain to what degree Australia’s comparatively successful performance in navigating through this catastrophe has been due to our own regulatory foresight or just good luck. We would do well not to discount the possibility that a ‘good roll of the dice’ left us without more significant system failures such as those seen in the UK. In future crises, we may not be so lucky.


This cataclysm was imposed upon us by the increasingly interconnected and globalised nature of capital markets. These interdependencies also extend to government policy. The catalytic event that was US sub-prime borrowers defaulting on home loans that barely exist in Australia pushed the world into a deep recession and has subjected Australia to a marked slowdown accompanied by significant job losses. As a nation with a large foreign debt that has continually increased its liabilities via enormous current account deficits, Australia’s vulnerability to foreign shocks is in many respects greater than most of our peers.


It is, therefore, critical that policymakers take this opportunity to thoroughly review the existing system and evaluate whether changes need to be made to it. Although the dependence of financial institutions on national governments has been reinforced by the crisis, global capital market integration is not going away. We have little comprehension of the consequences of the raft of new policies that are being implemented by other nation states. What effect will the whole or partial nationalisation of banking systems around the world have on Australian institutions and, more specifically, our ability to source foreign credit? Will the UK Government’s recent decision to guarantee securitised home loans along the lines of the Canadian model place Australian lenders at a competitive disadvantage in a global capital raising context? What are the long-term ramifications for Australia of the new regulatory regime being instituted by the Obama Administration?


These linkages cannot be ignored and should be examined under the auspices of a first-principles system review process similar to that undertaken by Campbell in 1981 and Wallis in 1996 with the benefit of new insights.


If there is any doubt as to why Australia needs to urgently revisit the foundations of its financial architecture, and evaluate what renovations might be required in light of the current crisis, consider that the following questions remain unanswered:


·  Will the Australian government seek to establish a regulated clearinghouse for the hundreds of billions of dollars worth of over-the-counter derivatives contracts that are otherwise beyond the remit of policymakers;


·  Should banks be subject to a ‘systemic capital charge’ to account for the risks associated with the correlation between bank balance sheets given that current capital charges reflect the idiosyncratic risks to the institution itself, and may not be collectively large enough to compensate for system-wide catastrophes;


·  Will the deposit and/or wholesale funding guarantees be phased out and, if so, what new policy guidelines will explain how they might be redeployed when capital markets seize up again in a manner that minimises disruptions to other sectors (such as the knock-on effects seen in non-guaranteed areas like the commercial paper debt markets, the mortgage trust industry, and the CMBS and RMBS markets). If they are not phased out, how will the terms and price of these subsidies be determined and what regulatory constraints will be applied to prevent the emergence of moral hazard risks. More broadly, what parts of the credit markets will or will not be guaranteed in the future;


·  Should APRA impose ‘automatic stablisers’ that require banks to accumulate capital in good times to serve as insurance against the bad;


·  Has this crisis reminded us that Australia’s major banks fulfill a unique community role akin to public-private utilities that warrant special controls to guard against system stability risks? Here it is odd that we’ve been repeatedly told that our banks were lucky not to have had substantial overseas exposures and yet they now appear to be rushing offshore to obtain exactly these;


·  What new regulations will govern executive compensation at banks and securities firms to mitigate the ‘call-option’ like payoffs that have tainted these arrangements in the past and how might these be tied to prudential supervision (eg, higher risk-weightings for firms that have short-termist structures and/or claw-backs on remuneration for executive negligence and adventurism);


·  Can real competition emerge while consumers face significant costs in switching between financial institutions? Does a government-regulated securitisation market provide an opportunity to consolidate mortgage account standards and more effectively enable switching;


·  Where government guarantees are deemed necessary is it preferable for them to be offered against complex institutions like banks, or against tangible portfolios of assets the characteristics of which can be relatively easily assessed by independent experts;


·  Should citizens who feel unsure and unqualified to shop wisely in our financial markets be able to access basic savings, payments, and wealth management products that have been vouchsafed by governments as being safe and professionally managed (eg, why can’t Australians invest with the Future Fund)? In this regard, is there a role for a publicly-owned entity, akin to KiwiBank in New Zealand, to offer essential services in Australia’s finance sector that leverage off unique government infrastructure (eg, Australia Post, the tax system, and the government bond market);


·  How will policymakers remedy the regulatory asymmetry between institutions like the larger banks that rely on short-term retail deposits as their primary source of funding (in combination with wholesale debt) and many of their competitors that depend on the longer-term and (ironically) ‘matched’ funding furnished by the RMBS market? Whereas banks benefit from a range of government subsidies (implicit and explicit deposit guarantees, term funding guarantees, RBA liquidity support, etc), which glue together the enormous asset-liability mismatch created by funding 30 year loans with at-call deposits, Australia’s regulatory architecture does nothing to maintain the liquidity and integrity of its securitisation market. This contrasts with the Canadian system, which has remained open and functional throughout the crisis (and displayed lower default rates than Australia);


·  Should the RBA ‘lean against’ incipient asset-price booms fuelled by increases in system-wide leverage;


·  Should Australia’s global foreign debt position be the subject of any general policy oversight and, if so, what measures should be pursued to ensure that these exposures are prudent;


·  What position should Australia take in relation to the restructuring of the global financial architecture? This will begin in earnest once it is clear that the worst of the crisis has passed. We need to be prepared for the negotiations that lead to new organisations, treaties and the global regulation of finance. For example, European states appear to favour a global super-regulatory body. The US has not embraced this approach. Where should Australia stand? And what will Australia’s views be on other key issues, such as the uniform global reform and regulation of rating agencies and hedge funds; and finally


·  What does Australia want to achieve from trade negotiations relating to the opening of foreign financial systems to overseas firms? Australia should be able to expand its supply of global financial services because of its location, political stability, resilient financial infrastructure, skilled workforce and competitive institutions. What steps will be taken to optimise Australia’s ability to both import and export financial services?


These are but a small subset of the many profound policy questions facing Australia and its financial system. Our relatively strong economic position offers an opportunity to review, investigate, consolidate and reform (if necessary). We need to take active steps to avoid the temptation of complacency and accept the lure of challenge. Only a full-scale independent commission on the financial system—roots and branch—can put us on a path to continued stability and insulation against the unpredictable. Following in the footsteps of Campbell in 1981 and Wallis in 1996, such a review’s time has now come.


Where’s the recession?

For many months now, I have been telling the continual tide of journalists calling to ask about the economy that (to paraphrase Bob Solow) “the recession is everywhere but in the statistics.” My expectation was always that it would appear in the Australian statistics. However, over the past couple of months the statistics have looked less and less recession like: unemployment down, consumer spending up, exports surging, house prices approaching their 2007 peaks and now GDP growth, the gold standard of recession monitoring, is up. Now people will point to various components of the statistics and dig deep to find worrying points but when it comes down to it, this wasn’t the recession that we expected to struggle to prove was there. Indeed, and I know this is completely unscientific, people don’t seem to be that recessed. Continue reading “Where’s the recession?”

Down the toilet

According to John Kay, what goes on in my household is, literally, critical for understanding the global financial crisis.

Rooned. We’ll all be rooned.

There is something about the way real estate trends are reported that borders on the irresponsible. OK. Real estate is the single biggest exposure that Joe and Jill Average have to the economic cycle and people are naturally interested. I get it. But bearing in mind the level of herd behaviour involved in any market, media exaggeration of any figure that can be converted into a sensational headline can only fuel irrational exuberance and despair.

Continue reading “Rooned. We’ll all be rooned.”

This American Recession

OK so information is depressing; even for an economist.

Those episodes are:

Competition in banking

Various views on the relationship between monetary policy and interest rates were expressed on this blog last week. I was concerned that a lack of competition was preventing interest rate pass through while Andrew Leigh was a little more relaxed about it if we get bank stability as a result. Finally, Sam Wylie is not convinced that monetary policy is wholly ineffective but then again wonders whether if the government wants to set mortgage interest rates it shouldn’t just do it. These posts are really different aspects of the same issue: how much competition in banking is optimal? This is a question that we don’t have a solid answer to at the moment.

In that light, a couple of pointers today. First, Peter Martin reports on additional concerns that smaller banks and non-bank lenders do not have sufficient funds to generate new mortgages. He reports on a suggestion by Chris Joye that the government’s AAA-rating be extended to back such mortgages (yet another aspect of a talked-out intervention). Second, David Warsh discusses John Geanakoplos’ notion that leverage is the key cyclical component and that monetary authorities have paid insufficient attention to it when thinking about regulation and monetary policy. In Australia, there is very little reporting of leverage components of loans. It would be nice to know more about what is going on there.