America will need a $1,000bn bail-out

By Kenneth Rogoff

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America's flagship financial sector, the public and private sector's massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

It is true that the US government has very deep pockets. Privately held US government debt was under $4,400bn at the end of 2007, representing less than 32 per cent of gross domestic product. This is roughly half the debt burden carried by most European countries, and an even smaller fraction of Japan's debt levels. It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, Wednesday's $85bn bail-out of the insurance giant AIG.

Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn.

True, the US Treasury and the Federal Reserve have done an admirable job over the past week in forcing the private sector to bear a share of the burden. By forcing the fourth largest investment bank, Lehman Brothers, into bankruptcy and Merrill Lynch into a distressed sale to Bank of America, they helped to facilitate a badly needed consolidation in the financial services sector. However, at this juncture, there is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury's most determined efforts, the political pressures for a much larger bail-out, and pressures from the continued volatility in financial markets, are going to be irresistible.

It is hard to predict exactly how and when the mega-bail-out will evolve. At some point, we are likely to see a broadening and deepening of deposit insurance, much as the UK did in the case of Northern Rock. Probably, at some point, the government will aim to have a better established algorithm for making bridge loans and for triggering the effective liquidation of troubled firms and assets, although the task is far more difficult than was the case in the 1980s, when the Resolution Trust Corporation was formed to help clean up the saving and loan mess.

Of course, there also needs to be better regulation. It is incredible that the transparency-challenged credit default swap market was allowed to swell to a notional value of $6,200bn during 2008 even as it became obvious that any collapse of this market could lead to an even bigger mess than the fallout from subprime mortgage debt.

It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps.

Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.

A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.

The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.

It is a very good thing that the rest of the world retains such confidence in America's ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.

 

Nationalisation ≠ Currency Weakness
September 19, 2008

By Stephen Jen & Spyros Andreopoulos | London

Summary and Conclusions

Conventional wisdom has it that, as a government fiscalises the contingent liabilities of nationalised banks, the currency of the country in question should depreciate.  More generally, banking crises are, very often, accompanied by balance of payments (or currency) crises.  The US, being a country with still out-sized 'twin deficits' (fiscal and external deficits), will likely see the dollar weaken because of the Treasury and the Fed's decision to effectively nationalise some of the large financial institutions, so the argument goes.  An inconvenient fact, however, is that nationalisation of banks, historically, did not tend to lead to further currency weakness.  In fact, very often the financial sector and the currency in question reach a trough just as the government takes steps to address the banking crisis.  Thus, currency weakness tends to precede, not follow nationalisation. 

Popular Thesis on Nationalisation and the Dollar

The notion that nationalisation of banks should lead to currency weakness is popular mainly because it is intuitive.  Since nationalisation of banks is 'not good news', and runs counter to the principles of capitalism and the free market, some have the visceral reaction to sell the currency in question. 

Further, as highlighted by Kaminsky and Reinhart (K&R) (see Graciela Kaminsky and Carmen Reinhart (1999), "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems", The American Economic Review 89: 3, June), there are many historical examples of 'twin crises', whereby banking crises and currency crises occurred simultaneously.  The more memorable examples include Argentina in the early 1980s, Sweden and Norway in the early 1990s, Japan in the late 1990s and Thailand in the late 1990s.  In fact, K&R found that, during 1980-1995, of the 23 banking crises, 18 were accompanied by balance-of-payments crises. 

This link between banking crises and currency crises is genuine, and the usual dynamics are well-summarised by ex-Governor of the Riksbank (Sweden's central bank) Mr. Bäckström (see What Lessons Can Be Learned from Recent Financial Crises? The Swedish Experience, Kansas City Fed Seminar in Jackson Hole, August 1997): "Credit market deregulation in 1985 … meant that the monetary conditions became more expansionary.  This coincided, moreover, with rising activity, relatively high inflation expectations, … (T)he freer credit market led to a rapidly growing stock of debt… The credit boom coincided with rising share and real estate prices… The expansion of credit was also associated with increased real economic demand.  Private financial savings dropped by as much as 7 percentage points of GDP and turned negative.  The economy became overheated and inflation accelerated.  Sizeable C/A deficits, accompanied by large outflows of … capital, led to a growing stock of private sector short-term debt in foreign currency".  This description applies quite well to the US right now.

Moreover, nationalisation of banks will increase the fiscal burden of the government.  For a country that already has a large fiscal deficit, this is clearly negative for the interest rate outlook.  For one that also has an external deficit, a large public borrowing need, ceteris paribus, should translate into a weaker currency, so the logic goes.  At the same time, the central bank may be tempted to 'monetise' the debt, or run a monetary stance that is easier than otherwise – again currency-negative.

The Inconvenient Historical Fact

While the arguments above may sound logical and compelling to many, the inconvenient fact is that the historical pattern of how currencies perform before and after nationalisation or bail-outs tells a very different story.  Averaged across five episodes of prominent banking crises, the nominal exchange rate tended to fall before nationalisation, but rise thereafter.  

The historical pattern suggests that financial markets tend to be forward-looking and try to price in the deterioration in the state of the banking system by selling down the currency and financial sector stocks, but the government is usually not compelled to act until conditions deteriorate significantly.  As a result, more often than not, government interventions have coincided with the lows in currency values.  In other words, even though K&R's observation that currency crises often occur simultaneously with banking crises is correct, there is no strong proof that nationalisation leads to further currency weakness. 

Other more visible examples are consistent with this link between banking crises and currency crises. The S&L Crisis and its bail-out spanned a protracted period of time.  The dollar index did continue to fall from 1986 – the beginning of the S&L Crisis – until 1989 or so.   (In 1986, the FSLIC (Federal Savings and Loan Insurance Corporation) – the deposit insurance scheme funded by the thrift industry but guaranteed by the government – first reported being insolvent (incidentally, the main reason why 1986 is remembered as the beginning of the S&L Crisis).  The RTC (Resolution Trust Corporation) was established in 1989, and by 2003, the RTC had 'resolved' US$394 billion worth of non-performing assets of US savings and loans.   (The total cost of the clean-up of the US S&L Crisis reached US$153 billion, in 'current' terms equivalent to some 2.6% of US GDP in 1991.  This translates to US$375 billion in 2008 dollar terms.)  The dollar index essentially moved sideways in the early 1990s.  The dollar did falter in 1994/95, but that was attributed more to the inflation scare than to the S&L Crisis.  Similarly, Japan's government did not explicitly address its banking crisis until 1998-99 and again in 2002-03.  After each episode, USD/JPY actually collapsed toward 100, i.e., JPY strengthened in the ensuing quarters.  Finally, in the case of Thailand, the banking crisis did indeed lead the currency crisis.  But bank bail-outs did not take place until 1998, and USD/THB drifted in the 36-42 range between 1998 and 2000 – significantly below the peak of 56 reached in January 1998. 

The case of the US at present is also illustrative.  Between the onset of the credit crisis in August 2007 and the collapse of Bear Stearns on March 16, 2008, EUR/USD rose from 1.35 to 1.58, and lingered around the latter level as the Fed and Treasury assisted other financial institutions in the subsequent months.  Since July, EUR/USD has collapsed from 1.60 to a low of 1.39 last week.  Even with recent dramatic events, there is no evidence that 'nationalisation = currency weakness'.  If anything, the dollar has held up remarkably well this week, despite several dollar-negative factors, including: (i) a higher probability of the Fed cutting the FFR than the ECB reducing the refi rate; (ii) a diluted Fed balance sheet, from the substitution of US Treasuries for other lower-rated securities; and (iii) large increases in the future fiscal burden of the US, from the contingent liabilities that are fiscalised.  In fact, the only dollar-positive factor this past week was lower oil prices.  EUR/USD seems to be drifting back toward 1.45, but we see this move as rather innocuous, given the severity of the financial stress in the US. 

In sum, banking crises are unambiguously bad for currencies, but nationalisation per se does not make the situation worse for currencies.  In fact, it often marks the low in the currencies. 

The US Fiscal Worries Over the Medium Term

Having said the above, the US does have quite a worrisome fiscal outlook in the years ahead, which may eventually have an impact on the dollar.  Setting aside the issue of the fiscal burden associated with the assistance the official sector has provided the financial sector, US expenditures may be too high and revenue buoyancy may be undermined by the weak equity and property markets. 

The Congressional Budget Office (CBO) released its budget update last week, and predicted that the US federal deficit will rise from US$161 billion (1.2% of GDP) in 2007 to US$407 billion (2.9%) in 2008.  This sharp deterioration in the fiscal balance reflects a simultaneous increase in spending and a decline in tax revenues.  (Total government spending will increase by US$226 billion, to close to US$3.0 trillion, reflecting both discretionary and mandatory spending.)    The CBO forecasts that deficits will remain above US$400 billion in each of the next two years. 

Investors will likely see it as key for the next Administration to control spending.  However, it is also important for investors to appreciate how sensitive US revenue collection is to GDP.  During 2001-02, for example, as the US economy fell into a brief recession, revenue collection plummeted from 21% of GDP to close to 16%.  Thus, the strength of the US economic recovery in the coming years will have important implications for the overall budget position.  These fundamental trends in revenue collection and 'core' spending are at least as important as the costs associated with nationalisation.  The performance of the dollar in the coming years will, therefore, be a function of how the US government deals with spending and how rapidly the US economy recovers, in our view. 

Bottom Line

Banking crises are bad for currencies, but nationalisation per se does not necessarily make it worse for currencies.  In fact, it often marks the low in the currencies.   We believe this is the case for the dollar in the current episode.  What remains a lingering risk for the dollar over the medium term is the US fiscal position, unrelated to the costs of nationalisation.

The Crisis of Global Capitalism?

On Sunday of this past week Merrill Lynch agreed to sell itself to Bank America, on Monday Lehman Brothers, a venerable major Wall Street investment bank, went into the largest bankruptcy in American history, while Tuesday saw the federal government partial takeover of AIG insurance company, one of the largest business insurers in the world. Instead of calming financial markets, these moves helped precipitate a complete collapse on Wednesday and Thursday of the market for short-term capital. It became virtually impossible to borrow money, and carrying costs shot through the roof. The Libor, or London interbank, lending rate sharply increased, as banks worldwide were reluctant to lend money. The rate on American treasury bills, and on short-term interest rates in Japan, even became negative for a while, as investors desperately looked for a safe haven in short term government bills.

The Treasury" extended deposit insurance to money market funds-without the $100,000 limit on deposit insurance. The Fed also began to take lower grade commercial paper as collateral for loans to investment and commercial banks, and the Treasury encouraged Fannie Mae and Freddie Mac to continue to purchase mortgage backed securities.

Is this the final "Crisis of Global Capitalism"- to borrow the title of a book by George Soros written shortly after the Asian financial crisis of 1997-98? The crisis that kills capitalism has been said to happen during every major recession and financial crisis ever since Karl Marx prophesized the collapse of capitalism in the middle of the 19th century. Although I admit to having greatly underestimated the severity of this financial crisis, I am confident that sizable world economic growth will resume under a mainly capitalist world economy. Consider, for example, that in the decade after Soros' and others predictions of the collapse of global capitalism following the Asian crisis in the 1990s, both world GDP and world trade experienced unprecedented growth. The South Korean economy, for example, was pummeled during that crisis, but has had significant economic growth ever since. I expect robust world economic growth to resume once we are over the current severe financial difficulties.

Was the extent of the Treasury's and Fed's involvement in financial markets during the past several weeks justified? Certainly there was a widespread belief during this week among both government officials and participants in financial markets that short-term capital markets completely broke down. Not only Lehman, but also Goldman Sachs, Stanley Morgan, and other banks were also in serious trouble. Despite my deep concerns about having so much greater government control over financial transactions, I have reluctantly concluded that substantial intervention was justified to avoid a major short-term collapse of the financial system that could push the world economy into a major depression.

Still, we have to consider potential risks of these governmental actions. Taxpayers may be stuck with hundreds of billions, and perhaps more than a trillion, dollars of losses from the various insurance and other government commitments. Although the media has amde much of this possibility through headlines like "$750 billion bailout", that magnitude of loss is highly unlikely as long as the economy does not fall into a sustained major depression. I consider such a depression highly unlikely. Indeed, the government may well make money on its actions, just as the Resolution Trust Corporation that took over many saving and loan banks during the 1980s crisis did not lose much, if any, money. By buying assets when they are depressed and waiting out the crisis, there may be a profit on these assets when they are finally sold back to the private sector. Making money does not mean the government involvements were wise, but the likely losses to taxpayers are being greatly exaggerated.

Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.

The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.

Various other mistakes were made in government actions in financial markets during the past several weeks. Banning short sales during this week is an example of a perennial approach to difficulties in financial markets and elsewhere; namely, "shoot the messenger". Short sales did not cause the crisis, but reflect beliefs about how long the slide will continue. Trying to prevent these beliefs from being expressed suppresses useful information, and also creates serious problems for many hedge funds that use short sales to hedge other risks. Their ban can also cause greater panic in other markets.

Potential political risks of these actions are also looming. The two Freddies should before long be either closed down, or made completely private with no governmental insurance protection of their lending activities. Their heavy involvement in the mortgage backed securities markets were one cause of the excessive financing of home mortgages. I fear, however, that Congress will eventually recreate these companies in more or less their old form, with a mission to continue to artificially expand the market for mortgages.

New regulations of financial transactions are a certainty, but whether overall they will help rather than hinder the functioning of capital markets is far from clear. For example, Professor Shimizu of Hitotsubashi University has recently shown that the Bank of International Settlement (BIS) regulation on the required minimum ratio of bank capital to their assets was completely misleading in predicting which Japanese banks got into trouble during that country's financial crisis of the 1990s. Other misguided regulations, such as permanent restrictions on short sales, or discouragement of securitization of assets, will both reduce the efficiency of financial markets in the United States, and they will shift even larger amounts of financial transactions to London, Shanghai, Tokyo, Dubai, and other financial centers.

Finally, the magnitude of this crisis must be placed in perspective. Although it is the most severe financial crisis since the Great Depression of the 1930s, it is a far far smaller crisis, especially in terms of the effects on output and employment. The United States had about 25 percent unemployment during most of the decade from 1931 until 1941, and sharp falls in GDP. Other countries experienced economic difficulties of a similar magnitude. American GDP so far during this crisis has essentially not yet fallen, and unemployment has reached only about 61/2 percent. Both figures are likely to get considerably worse, but they will nowhere approach those of the 1930s.

These are exciting and troubling economic times for an economist-the general public can use less of both! Financial markets have been seriously wounded, and derivatives and other modern financial instruments have come under a dark cloud of suspicion. That suspicion is somewhat deserved since even major players in financial markets did not really understand what they were doing. Still, these instruments have usually been enormously valuable in lubricating asset markets, in furthering economic growth, and in creating economic value. Reforms may well be necessary, but we should be careful not to throttle the legitimate functions of these powerful instruments of modern finance.