Monday, February 23, 2009


A proud achievement of Monetarism was political independence for central banks. This has especially been so in Europe, notably the EU's Maastricht Criteria, the UK granting of independence to the Bank of England in 1997 and the formation of the European Central Bank to support the Euro Area. Independence of various kinds has been granted the world over from North America to S.Africa and Japan. The financial crisis and worldwide recession and dramatic changes to world trade and payments flows has ended all that! Contrast the International Monetary Fund (IMF) with the Bank of International Settlements (BIS), and ask yourself why it is that the former and not the latter is the G20 choice for the new global financial regulator and custodian of the new 'financial world order' that G20 is working on with immense urgency? The IMF was established after WW2 and has 187 members and is doubling its capital to $500bn. The BIS was established in 1930 and has only 55 members. The IMF has powerful political profile and is HQ'd in Washington. BIS has failed to play up a politically important profile. It believes in the anaemic world of staying in the shadows, the world of 'shadow-central banking'. It is HQ'd in Basel, Switzerland. It is not without transatlantic and global influence. It has a full quota of Anglo-saxon bankers. It has far deeper expertise in banking regulation and central bank coordination than the IMF! BIS also already has over $500bn in funds and has had twice this in the recent past. But, combining the IMF with the BIS does not yet appear to be on the G20 political agenda; it is either or? And here we get into what is a spaghetti dish of global issues that I shall endeavour to fork out some key strands. The US Treasury, The Federal Reserve, FDIC, and The Comptroller of the Currency, Fannie Mae and Freddy Mac none of these have an ounce of political independence any longer. The European central banks and regulators, BoE, FSA, IFRSA, DNB, BoG, CBFA, and most, but not all, of the rest are no longer politically independent for any practically useful purposes. 'Independence' for now and the forseeable future is just a fashion statement that's so over, a passing fad, gone, buried, but not buried forever! Central Banks that stick out as behind this curve are the European Central Bank (ECB), the European Bank of Reconstruction & Development (EBRD), and BIS. They better wake up and get with the new global G20 political-economy agenda! The figures below are the optimistic estimates from October 2008. Now it looks as if even China may dive into recession in 2009, in which case the other emerging market economies may possibly do so too! The estimates for the OECD countries already look high for 2009. But, with fiscal stimulus policies in place, there is a chance of recovery starting by or just before 2010. It is the worsening of global figures in recent months that is concentrating European minds to agree with the fiscal policy priorities of the G20 agenda, even if it is unpalatably Anglo-American? BIS has a new Chairman, Guillermo Ortiz, Governor of the Bank of Mexico (which with the Central Bank of China joined BIS in 2006). Mexico's banking crisis is useful experience. Ortiz's term is for a period of three years, commencing on 1 March. he should see out the worst of the present crisis.
Europe. the EU, of course to be expected of 25 nations, is flummoxed and jostling between where the weight of new political-economy thinking and cross-border banking regulations should reside? Should it be the ECB if given more political-backing by the European Council (EC) or by the European Parliament (EP), or by the European Commission (backed by the EC and or EP), and or the Committee of European Banking Supervisors (C-ebs), and or BIS (author of Basel I and Basel II and producer of the world's cross-border financial statistics) that also convened the Financial Stability Forum (SFS). There is no clear answer possible, not even within Europe, hence the default choice will be the US/UK one of the IMF.
Also, highly important and usually least discussed, is the Group of Thirty which shares many senior figures with BIS and IMF and is also based in Washington. It is pursuing work programmes in many of the same areas including standards, see
One issue of the IMF structure is voting power. That is what China and other new members want if they are to donate some of their sovereign funds. The board members of the IMF representing all members have votes proportionate to their economic size e.g. roughly USA 17%, Japan 6%, Germany 5%, UK 4%, France 4%, Italy 3% and so on. China will want 5-6%, even if the true size of its economy justifies 4%. But, there are $5-6tn of bank balances in China as well as $2tn foreign currency reserves. What the crisis has rediscovered is the political importance of central bank functions - undoing what monetarists did by officially evacuating politics out of Central Banks. Monetarism sought to depoliticise not only monetary policy but also fiscal policy e.g. Europe's Mastricht Criteria. Now, if ECB, BIS or any other can't play along to the political tunes of how to regain financial normalcy and economic recovery then they're useless - hence the US/UK leading the G20 agenda to the IMF! As soon as Government politicians realise they must grab back responsibility for finance, as essential to political-economy, central bank political independence has dead! Germany and France and others have fought against this re-politicisation, but they are outgunned and undermined by their own fast deteriorating economic problems.
In Europe, the view is that stepping over, around or away from BIS is stupid and wrong, except that there are some undoubted strengths of the IMF that the BIS simply is not yet matching, and arguably never has. Critical to the G20 agenda is 'Third World Countries' (3WC) support, UN /GATT DOHA Round's 194 (also called emerging markets, especially BRIC countries, and poor developing countries) and the IMF appears best positioned for this, to get 3W countries support for global prudential regulation and who will 'buy in' if they are not seen taking orders from an IMF that merely speaks for the USA/UK/EU, or not unless there is money attached. The IMF is currently seeking to double its funds to $500bn, which should suffice for the next 6 months and then it needs more. BIS has $500bn already, but this is tied up in supporting blobal balance of payments tranfers, something the IMF was also originally set up to support.
From the US point of view a big issue is the IMF role world hotspots (hot wars) and the global credit crunch is feared as a generator of many more such hotspots. The G20 agenda is focused on prudential regulation of banking as emphasised by the EU's Berlin conference on Sunday in preparation for the G20 London Summit in April. But, hard currency trade payments payments and Debt Relief are even more urgent. This has been masterfully picked up by the IMF's Dominique Strauss Kahn. He has positioned the IMF by what BIS, the ECB and EBRD relative to Eastern Europe and N.Africa should have done but didn't.
The IMF got involved in the FSF and became the supporting bureaucracy for G20 and studied 122 banking crises around world and found (no surprises here), that banks' balance sheets must be cleaned up for real recovery to begin, and banking sector can start distributing credit only once it has shrunk and it's been cleaned up. This is frightening to Governments who fear their domestic bank lenders deleveraging by 10-30%, easily enough to turn a crisis into stagnation.
The IMF also looks like a place to invite Sov.Funds into, to address intra-3WC transfers, to attract some investment by Soverign Funds' and to take on some of their holdings of US ABS that otherwise might be dumped back into the USA? The US can call what it lends to IMF as fundings when really they can be $ treasuries swaps for US ABS via the IMF and best done while the $ exchange rate is riding high. The
IMF unlike BIS or ECB or the World Bank can speak out with political authority and politically-attuned economic forecasts. The IMF might have a role in stopping some wars by mitigating crisis or funding reconstruction. The BIS doesn't have any of that political profile. It is too much like a global regulator and too little like a global central bank. The IMF believes in a combination of 4 set of measures to get the world back on track: 1. action by many governments to stabilize fin. markets to get credit flowing again. The IMF does not have a clear analysis of what this entails. I supply that. This is a combination of capitalisation measures, replacing 100% of banks' reserve capital (in US & Europe about $2.5tn), and central banks stepping in to provide wholesale market funding to fund banks' 'funding gaps'. (In the USA, the funding gap is up to $8tn, in Euro Area, $4.5tn, in UK $1tn and in Central and Eastern Europe, including Russia, $1.5tn. In China and Japan and India the 'funding gap' is another $4tn or so = $18tn worldwide). US, UK and Euro central banks have so far financed about 20% of what is required over 3 years. This role, displacing private sources from what had been a highly profitable business by banks and near-banks, should be medium term very profitable to governments and a serious loss of income to banks, while at the same time saving their hides. 2. Fiscal stimulus by higher government borrowing and spending. The IMF conservatively prefers to say higher government spending & tax cuts to revive economic consumtion (mainly consumer demand) and world trade. The IMF's emphasis on tax cuts is its hat-doffing to the monetarist orthodoxy of the past 30 years, including its last November package for the Ukraine, of which it has been a passionate supporter (sometimes notoriously so in Africa and S.America). The US and UK are aiming at 8% fiscal stance, which may translate into 4-5% GDP boosts, but 5% is the least needed to get back to 2003 financial balances of banks and onto a palpable recovery path. The EU is dithering around a more minimalist 2.5% but edging upwards to 5%. The fiscal stimulus rule should be that it is better and safer to do too much than too little. Monetarists in the wings worry traditionally about the inflation consequences of higher government indebtedness and spending. This view has however ignored the consequences of far faster growth of private sector debts that are also a concern of monetarist theory if only most monetarists were that versed in their own theories? 3. The IMF is rightly very concerned about supplying liquidity to Emerging Market Countries from where there has been a fall-off in Foreign Direct Investment, severe drop in export volumes, stock market and other financial outflows because of the financial crisis, repatriation of funds to the USA and 'safe-haven' panic into US dollars, Yen and Euros. The context of this is also very much that of hard currency reserve balances which in 3WCs are, along with minerals and cash-crop future exports, what supports 3W central bank domestic money supply. 3WCs lack domestic bond markets alongside lacking 'tradeable currencies' - something the World Bank has become keen to address but has so far not achieved much publically. 4. The IMF wants to help Low-Income Countries harmed by the financial crisis and the legacy from the price spiked in 2008 in food & energy prices, now followed by total insecurity about 2009-11 trade. The global trade pattern is entiely up-in-the-air and falling in volume and value, and no-one has predicted how it will settle. All we can be sure of is that all economies have to look harder at domestic growth impulses and realise that they will be less reliant for some years on their external account. All we know is that energy will remain half od all world trade. The IMF proposes governments in a position to do so should together inject a global fiscal stimulus (presumably to poor Cs) equivalent to 2% of world GDP = $1.2 trillion, which is four times the IMF's current balances and a third of the true GDP of China. A million jobs less in the EU or the USA each supports twenty millions of jobs in China. IMF head, Dominique Strauss-Kahn, former French finance minister, who along with Gordon Brown got President Sarkozy on-side in G20, telling him to hold back on his Europhile objections, by both telling him that the world avoided a total meltdown of the financial system only as a result of coordinated intervention by major central banks last October, as led by the US and UK. "We were very close in September to a total collapse of the world economy." Strauss-kahn defends the IMF's different prescriptions for different economies, arguing that while major advanced economies could afford to boost spending and run up larger deficits to help get out of the recession, other crisis-hit countries, particularly emerging markets of E.Europe, do not have the same budgetary room of maneouvre because inflows of capital dried up and their currencies were under pressure. The irony of this is that similar problems arise even in the most rich Euro Area!
When the Euro was launched (replacing 10 currencies, now 15) the ECB was set up to back the currency including the central money market operations on behalf of the Euro. This meant that Euro-member states' central banks lost the flexibility to issue their own treasury-bills (government bonds with less than 1 year maturity). T-bills have the advantage of being off-balance sheet of government budgets and national debt. It was through treasury bills more than any other measure that both the US and the UK were able to respond quickly and powerfully to relieve the liquidity crises hittin the banks. The ECB has followed suit, but less quickly and proportionately less. The ECB's liquidity window ran into political problems e.g. why did the Irish get so much relative to their economy; answer, because they have a disproportionately large banking sector? The ECB is also least able to take on political direction and least comfortable with more of a fiscal than a monetary intervention. It has been constitutionally set up entirely to implement monetary policy and to use Euro-bills for that, not to save banks or save economies by in effect acting fiscally. The fear of expanding ECB bills issue from €800bn to €5tn is he fear that this would undermine the creditrowthiness of the Euro. But, the choice of not doing so means Euro Area countries busting through their budget deficit and National debt limits as defined by the Maastricht Criteria - and that would politically be even more of a threat to Euro currency integrity! It may be best for the economy of Europe and ultimately of the Euro system for the ECB to delegate back to national central banks the right to issue treasury bills and operate their own liquidity windows for domestic systemically important banks, only limited by the current funding gaps. This could be a very important innovation, but I know of no-one else suggesting this, except myself!
Strength of the dollar is proving to be a boon to the $2.5tn or half of US asset backed toxic securities bought by foreignors, but not in the Euro Area. The high US$ is also a big factor in the low oil price. But, IMF and US criticism of the ECB as not being a real central bank with real political backing and not operating a sufficiently large liquidity window or forcing European banks to write-down their toxic assets far enough ($250bn too little) is all conjoining with bad economic news to pull down the Euro (good thing too). The UK is pulling the EU leaders in the direction of debating fiscal measures and financial bailouts. Germany and France have sought to pull the debate as they achieved in Berlin more in the direction of reguylatory cures for excessive financial risk, seen as essentially the curse of the Anglo-American or Anglo-saxon economic system and culture. Dominique Strauss-Kahn sits comfortably astride this divide, and can say that even though the financial crisis had started in the United States, the recent strength of the dollar showed that people around the world still had confidence in the U.S. economy. He seems thereby to be saying that US recovery has to be the engine that needs to start pulling before everyone else's recovery can get ging and that is quite right. As long as that confidence remained, the United States would be able to finance its large deficit. Even though the Chinese and other BRIC economies were on the rise (with a true GDP in China's case one third less than measured officially), even with reflaion packages of some size being possible as in China, the United States remains overwhelmingly formidable as the main counterparty economy and by far the major trade currency to the whole of the rest of the world. But, all economies remain dependent on the rest of the world. Therefore, the IMF takes the sensible view (and the UN also) that recovery measures cannot be merely domestic and must include how to fix the serious imbalances in the global economy. How big a part new global banking risk management regulation can play is uncertain. My view is that it is dangerous to throw regulatory authority pieces up in the air to create a new jigsaw. We should work with what we've got and create a new system when recovery is certain. Member governments expect the Group of 20 industrialized and emerging market economies to make significant progress in boosting transparency and tightening supervision in the financial sector when they meet in London in April. The London meeting follows the meeting in Washington last November when leaders first agreed an action plan to combat the growing crisis that places global financial regulation at the top of the agenda.
For final confirmation that central bank political independence is now passed and the focus is not longer on monetary aggregates and inflation only, we have only to consider Monday's statement below from The Fed, Tuesday's Ben Bernanke testimony before Congressional Committee (see 2nd of comments here below), and Wednesday's launch of C.A.P. "Capital Assistance Program." The U.S. Department of the Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve Board on Monday, Feb 23rd issued the following joint statement:
"A strong, resilient financial system is necessary to facilitate a broad and sustainable economic recovery. The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses. The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth. Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.
"We announced on February 10, 2009, a Capital Assistance Program to ensure that our banking institutions are appropriately capitalized, with high-quality capital. Under this program, which will be initiated on February 25, the capital needs of the major U.S. banking institutions will be evaluated under a more challenging economic environment. Should that assessment indicate that an additional capital buffer is warranted, institutions will have an opportunity to turn first to private sources of capital. Otherwise, the temporary capital buffer will be made available from the government. This additional capital does not imply a new capital standard and it is not expected to be maintained on an ongoing basis. Instead, it is available to provide a cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers. Any government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory. Previous capital injections under the Troubled Asset Relief Program will also be eligible to be exchanged for the mandatory convertible preferred shares. The conversion feature will enable institutions to maintain or enhance the quality of their capital.
"Currently, the major U.S. banking institutions have capital in excess of the amounts required to be considered well capitalized. This program is designed to ensure that these major banking institutions have sufficient capital to perform their critical role in our financial system on an ongoing basis and can support economic recovery, even under an economic environment that is more challenging than is currently anticipated. The customers and the providers of capital and funding can be assured that as a result of this program participating banks will be able to move forward to provide the credit necessary for the stabilization and recovery of the U.S. economy. Because our economy functions better when financial institutions are well managed in the private sector, the strong presumption of the Capital Assistance Program is that banks should remain in private hands."

The financial authorities have provided funding assistance variously to replace that part of banks' reserve capital that has been lost due to the credit crunch. TALF and other measures will provide Government supported and private undewritten funding of banks' 'funding gaps'. Now CAP: this is the authorities offering to underwrite and supply on an assessed-needs basis the additional reserve capital cushion that banks should have in place to absorb capital reserve losses caused by credit risk and market risk losses caused by recession. All the banks know is that how they have correlated their economic capital model risks to what is currently happening has been woefully inadequate and they must now do this more intelligently, more globally and more severely. The boards of the biggest banks are all directly involved in this and the best brains and systems are being mustered urgently this week to do so in all banks' headquarters working round the clock. They have to do the work in days that normall would take a team of PH.Ds months to complete. They will do the best they can. It won't be very good, but it's a start and certainly is concentrating top minds. I've got the answers already sufficient to predict the rough outcome. The correct result should be $1 trillion of capital reserve cushion as the 'economic buffer'.
The next blog will explain this and in the context of stress-testing by the US banks that will be followed in UK and the rest of Europe. Failures by banks to know how to stress-test and failure to stress test severely enough is considered by many to be a root cause of the present crisis. Hardly anyone seems to know how to do this properly, including BIS, The Fed and other regiulatory and supervisory aiuthorities. In and elsewhere myself and colleagues are providing detailed advice on how to do this work realistically, comprehensively and successfully.

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