Some lessons from the sub-prime crisis responses

There are very few counterfactuals in social sciences. The closest to such a counterfactual are the contrasting responses of US and Europe to resolving their respective financial market crises. Though in recent months, Europe has taken steps to emulate the US, the initial responses across both sides of the Atlantic bear a striking contrast.

In the US, at the first signs of the sub-prime crisis bursting, the Treasury and the Federal Reserve aggressively intervened to contain the damage. The Treasury came forward with its Troubled Assets Relief Program (TARP) to directly assist the beleaguered banks and other financial institutions with equity injections. The Federal Reserve expanded its balance sheet many times and initiated quantitative easing programs to emerge as the lender, insurer, and buyer of last resort for the financial markets.

However, across the Atlantic, driven both by lack of similar political resolve and strong ideological predilections, the Eurozone governments and the European Central Bank refrained from aggressive intervention. They let events take their own course in the hope that markets would soon resolve the issue. Credit markets froze, driving up sovereign debt yields and nearly shutting off the peripheral economies. Banks, saddled with massive sovereign debt exposures, stumbled to the brink. The ECB refused to lend either to the banks or the battered sovereigns. It stepped in finally only when the situation had worsened considerably.

The contrasting fortunes of both economies, atleast their respective financial sectors, is a clear verdict on the policy courses followed on both sides of the Atlantic. Europe stares at a potential Japan like financial dystopia, whereas American financial institutions have recovered smartly and are back to doing all those things that caused the sub-prime crisis! However, there are a few quick learnings from the situations across both sides,

1. The loudest message from the two different courses of action is that markets do not repair themselves and when faced with such deep financial market crises, governments and central banks have to step in with aggressive policies.This becomes all the more important as the complexity of our banking systems increase and the too-big-to-fail syndrome become entrenched.

2. Related to this is the central and disproportionate importance that financial markets have come to assume in determing the economic fortunes of a country. Despite the fact that the financial sector occupies a far less share of both the economy and the working population, its good health is critical to the fortunes of any modern economy.

3. Similar to the stark contrast between the US and European responses is the difference between the responses by the US Government and the Fed to the condition of over-leveraged financial institutions and debt-ridden individual households. The latter received nothing like the unlimited and cheap liquidity injections, debt rescheduling at very favorable terms, and sweeping credit guarantees offered to the financial institutions. Household foreclosures, even when it happened in a massive scale, became a source of concern only when it threatened to affect an exposed financial institution.

In other words, the disciplining elements of the free-markets are reserved for individual households and small business firms, while the financial sector behemoths, the much trumpeted success stories of deregulated free-market capitalism, face no such constraints. The negative externalities created by financial institutions do not get internalized.

4. All this highlights the increasingly sharp cleavage between the real economy and the financial markets. Are the gains of the financial markets, especially their outsized wins, coming at the expense of the real economy? Is there a recession or even a depression lurking at the end of a sustained period of financial market boom? The financial markets, especially in their current avatar, appear to have become too big a systemic risk to be left as it is.

The "mother of all bailouts" unmasked!

A Bloomberg investigation has revealed the stunning magnitude of the post-Lehman financial market bailout. Hitherto information about only the $700 bn Troubled Assets Relief Program (TARP) was made public and the details of the liquidity injection facilities were withheld on grounds that it would stigmatize borrowers and thereby destabilize market confidence. However, it now emerges that the Fed's liquidity infusion support dwarfs the TARP and should rightly assume the moniker of the "mother of all bailouts"!

As the crisis deepened, the Fed had to expand its traditional discount window to provide liquidity support to the frozen credit markets. By the end of 2008, the central bank had established or expanded 11 lending facilities catering to banks, securities firms and corporations that couldn’t get short-term loans from their usual sources. Such credit support involved reduced credit standards and collateral requirements.

The report finds,

Add up guarantees and lending limits (to direct lending), and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the US that year... The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy.

While TARP credit had some strings attached, the liquidity injections came without any conditions attached and was a virtual doleout. And these banks, including foreign ones, profited by atleast $13 bn from the Fed's below market lending rates. It is no wonder that the Fed and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. The report writes that the witholding of this information helped the banks ward off pressures for greater regulatory oversight,

Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse... While Fed officials say that almost all of the loans were repaid and there have been no losses, details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger.

The hypocrisy of concealing the fact of being under life-support while at the same time publicly claiming stability and strength is captured in the report,

"On Nov. 26, 2008, then-Bank of America (BAC) Corp. Chief Executive Officer Kenneth D. Lewis wrote to shareholders that he headed 'one of the strongest and most stable major banks in the world'. He didn’t say that his Charlotte, North Carolina-based firm owed the central bank $86 billion that day."

On Sept. 21, 2008, a week after Lehman went bankrupt, Goldman Sachs converted to a bank holding company, gaining access to the Federal Reserve's last-resort lending program for banks, the discount window. While it took only $50 million from the window, New York-based Goldman Sachs had been borrowing from the central bank for six months from two temporary programs for broker-dealers: the Term Securities Lending Facility and the single-tranche open market operations, or ST OMO. On Dec. 31, 2008, Goldman Sachs had $34.5 billion of loans from ST OMO, some of it at an interest rate of 0.01 percent. "We weren't relying on those mechanisms", Goldman CEO Lloyd Blankfein told the Financial Crisis Inquiry Commission in January 2010.



The exposures of the six biggest financial institutions were staggering. The six biggest US banks, received $160 billion of TARP funds and borrowed as much as $460 billion from the Fed (measured by peak daily debt), and accounted for 63% of the average daily debt to the Fed by all publicly traded US banks, money managers and investment-services firms.



See the interactive graphic here.

Is monetary accommodation becoming a dogma?

When history of the tumultous period of the Great Recession will be written, central bankers will be among its dominant characters. All along the crisis, across the world, monetary policy has been the predominant and preferred choice to fight both financial market instability and boost aggregate demand.

In a recent blog post, Brad DeLong echoed this view when he advocated further massive expansion of the Fed's balance sheet and committing to a target nominal GDP growth. He writes,

"The Federal Reserve might be able to spark a real economic recovery by... announcing that it is going to keep short-term Treasury interest rates low not just as long as the economy is depressed but even afterwards when the economy has recovered and when it would normally be raising interest rates: that it is going to keep short-term Treasury interest rates low until it generates an inflationary boom, and that you had better start building capacity now to serve your customers during that inflationary boom or your competitors will do so and take your profits...

If I were in the hot seat, I would follow the Jan Hatzius plan: (a) take the Fed's balance sheet up to $5T over the next two months, and (b) say that if that turned out not to be enough to get nominal GDP growth to a path that will return it to its pre-2007 trend within three years, that I would then keep interest rates low and take the Fed's balance sheet even higher until it did."

A similar debate is being played out across the Atlantic in Europe. With the Eurozone economies grappling an existential crisis, there have been calls for the ECB to emulate the Federal Reserve and indulge in aggressive monetary policy to stabilize financial markets. A leading advocate of such measures, Wolfgang Munchau wrote,

"The European Central Bank must agree a backstop of some kind, either an unlimited guarantee of a maximum bond spread, a backstop to the EFSF, in addition to dramatic measures to increase short-term liquidity for the banking sector. That would take care of the immediate bankruptcy threat."

More specifically, in addition to advocating a fiscal union, he favors unconventional quantitative easing and issuance of large enough joint-and-several liability eurozone bonds. On same lines, James Surowiecki has called for the ECB becoming the lender of last resort for the embattled European economies,

"If the European Central Bank were to commit publicly to backstopping Italian and Spanish debt, by buying as many of their bonds as needed, the worries about default would recede and interest rates would fall. This wouldn’t cure the weakness of the Italian economy or eliminate the hangover from the housing bubble in Spain, but it would avert a Lehman-style meltdown, buy time for economic reforms to work, and let these countries avoid the kind of over-the-top austerity measures that will worsen the debt crisis by killing any prospect of economic growth."

The suggestions of DeLong, Munchau, and Surowiecki are representative of policy prescriptions on both sides of the Atlantic calling for aggressive measures to restore economies to their pre-crisis normal. The monetary policy bias is very distinct.

As I have blogged earlier, advocates of such policies suggest them more out of desperation than from any strong conviction. There is a strong urge to throw everything and the kitchen sink at the intractable problem and hope that something will click. Brad DeLong himself writes,

"How well would it work? We don't know. Are they worth trying? I certainly think so..."

While all such accommodatory policies will surely contribute towards backstopping losses and stabilizing the markets, there are two important questions. One, given the circumstances, how effective will be such policies? Two, what are the costs - direct and secondary market distortions - associated with this?

A honest assessment of both these questions will raise disconcerting answers. The severity of the crisis, on both sides of the Atlantic, means that the magnitude of monetary accommodation - liquidity injections and indirect debt guarantees - required to meaningfully and sustainably stabilize the financial markets is beyond the abilities of most central banks and governments.

Further, the secondary market distortions that are certain to be set off by such sustained and extra-ordinarily large monetary accommodation will certainly challenge global financial market stability. It will perpetuate many of the bad practices that contributed towards the sub-prime era financial market excesses - regulatory arbitrage, TBTF, mis-pricing of risk etc. This monetary accommodation and flood of liquidity has the strong likelihood of generating another round of resource misallocation in the financial markets. It will also expose the emerging economies to the vagaries of massive cross-border capital flows, with all its attendant adverse consequences.

Much of the academic debate that feeds into policy making has been on exploring alternatives to get the economy back to its pre-crisis normality at any cost. This line of thinking glosses over questions about whether the old normal is itself desirable. There is a strong case that the quarter century of Great Moderation, with its low unemployment rate and inflation coupled with high growth rates, was the result of a fortunate confluence of favorable factors. The dynamics generated by China and the emerging economies, a big wave of trade and financial market liberalization, and dramatic productivity improvements generated by advances in information technology contributed to the Great Moderation.

The past 15 years, atleast since the late nineties, has been an era of unprecedented complementarities. The emerging economies saved to cheaply finance consumption and deficits in many parts of the developed world. Cheap exports of consumer durables and non-durables served to keep inflation low across the world. The consumption boom in developed economies also kept up the demand for commodities from many developing countries. It was over-optimistic to imagine that these forces would maintain their momentum forever.

In the process of this era of extraordinary stability and growth, several distortions and imbalances had become institutionalized into the world economy. The monetary-pump-prime-your-way-out of recession fails to acknowledge that the efforts to restore normalcy would serve to perpetuate many of the same distortionary trends and policies that fuelled the crisis. For example, there is enough evidence that the ultra-low rates have benefitted the remaining big financial institutions, who have used the opportunity to grow even bigger and pose even greater systemic risks.

Apart from resolving the extant problem, every crisis is also an important opportunity to wring out the excesses of the bygone era that was in the first place responsible for the crisis. In this case, the later can be done both by letting those responsible pay for their recklessness and greed (after all this is the primary incentive formation and disciplining mechanism of capitalism) and by refining regulatory policies to pre-empt such future failures. Unfortunately, influential opinion makers across the world have been focussed more on exploring options to get the economy back to its pre-crisis normal instead of doing the hard problem solving to get things back to a more efficient and desirable "new normal".

Update 1 (3/12/2011)

In a move to ease Eurozone's debt squeeze, the Federal Reserve, ECB, BoE, BoJ, SNB, and Bank of Canada announced that they would reduce by about half the cost of a program under which banks in foreign countries could borrow dollars from their own central banks, which in turn get those dollars from the Fed. The banks also said that loans would be available until February 2013, extending a previous deadline of August 2012. This move effectively makes the Fed emerge as the global lender of last resort, lending dollars to foreign central banks so as to ease credit markets there. The move is intended to free up liquidity and ensure that European banks have funds during the sovereign debt crisis and keep borrowing costs down for consumers and firms.

These are loans between central banks rather than loans to individual foreign banks, there is very little risk to US taxpayers. However, in the face of ECB's reluctance to buy debt of the most beleaguered Eurozone economies and work as the risk absorber of last resort, this is the closest that the Fed can get to effectively doing ECB's job and purchasing foreign government debt itself.

The Great Macroeconomic Policy Debate - How to restore growth?

The biggest macroeconomic challenge now is to manage a recovery from the stubbornly persistent economic slowdown. But a fierce ideological battle is on about what strategy is required to achieve economic recovery.

Everyone agrees that across both US and large parts of Europe, household, bank, and government balance sheets are suffering from huge debt over-hang. As households cut back on consumption and banks refuse to lend, businesses are postponing investments. The high unemployment rates show no signs of coming down and the economies remain stuck at the trough, far longer than the aftermath of previous recessions. Governments, the only other agency capable of engineering a turn-around, are faced with huge sovereign debts and battered fiscal positions. With interest rates at zero bound and even extraordinary quantitative easing measures already having been tried out, monetary policy appears to have limited traction. So what is the way out?

Conservatives are unambiguous in their advocacy of fiscal austerity and placing deficit reduction at the center of the macroeconomic agenda. They fear about the dangers of inflation taking hold and bond-market yields rising. They claim that the fiscal and monetary expansion of the last decade or so has produced several excesses that need to be wrung out before any meaningful economic recovery can begin. To this extent they advocate immediate re-balancing of public finances with policies to cut government expenditures, raise revenues (albeit without raising taxes), and carry out structural reforms.

They admit that while this will generate some short-term pain, it will be for the long-term good. They argue that this will generate "contractionary expansion", restoring market (business, investor, and consumer) confidence and shaping expectations and thereby encouraging business investments. See Robert Barro (academician), Stephen King (Business), and Wolfgang Schauble (politicians) advocating austerity and fiscal consolidation over expansion.

Liberals differ and propose further fiscal and monetary expansion as the only way out of this mess. The argue that the high persistent unemployment rates should be the central focus of policy makers. They point to historical evidence from US in 1930s and recently from Japan, to argue that unless governments undertake aggressive Keynesian stimulus spending and unconventional monetary expansion, the economy risks being stuck at the bottom for a long time.

They also point to the evident inability and reluctance of businesses to invest in such uncertain and weak environments, especially that of the job-creating but credit constrained small businesses. They see government spending as the only source of generating additional aggregate demand. They also argue that the ultra-low interest rates provide an excellent opportunity for governments to invest in infrastructure and other long-term spending so that the platform for longer-term growth is laid at the cheapest cost. They see little evidence of government spending crowding out private borrowing, inflation emerging as a concern anytime soon, or bond-markets catching cold. See Martin Wolf (Journalist), Mark Zandi (Business), Adam Posen (policy maker) and Dani Rodrik (academician) advocating expansionary policies.

There are also some others who have refrained from taking an explicit position, preferring to suggest specific measures. Some like Ken Rogoff have rightly argued in favor of policies that directly address the issue of cleaning up household and bank balance sheets. To this extent they advocate inflating away debts with a slightly higher inflation target, something which Olivier Blanchard, the IMF Chief Economist too had advocated earlier. However, the efficacy of higher inflation targeting has been questioned on credible enough grounds by Raghuram Rajan.

Interestingly, both sides invoke the magisterial historical examination of sovereign debt crisis, induced by various factors including banking collapses, by Carmen Reinhart and Kenneth Rogoff. Conservatives point to their finding that high-levels of growth dampen growth. Liberals point to their findings about the deep nature of recessions that follow banking collapses and argue that government support therefore is essential for expediting recovery.

All these views carry considerable ideological baggage and are evidently constrained by the need to accommodate their respective ideological predilections. Warts and all, the main issue is about which mixture of policies would be most effective in enabling a sustained recovery. An objective assessment reveals inconsistencies or practical difficulties with both sides.

The problem with the conservatives' position is that if all the actors - governments, businesses, financial institutions, and households - are badly constrained, then where would the thrust for recovery come from? Their argument is that debt restructuring and the dynamics that get generated could restore market confidence and thereby pull the economy up the recovery path. But, given the depth of the problems, will it carry the momentum required to pull the economy out? Even traditionally conservative institutions like the IMF have raised serious doubts about fiscal austerity arguing that it could hurt incomes and job prospects. Further, the experience in the current recession with such policies is hardly encouraging.

As several estimates of growth required to bring unemployment in the US to normal levels and also bridge the yawning output gap show, the scale - magnitude and time - of growth required to restore normalcy in the medium term is substantial. In the absence of a strong engine or anchor, what will be the source of this growth? The justifiable fear then is that the recovery process could go on for years.

The fundamental premise of the liberals' argument is that it is necessary to do everything possible to pull the economy out of recession. They fear, based on historical precedent, that in the absence of aggressive expansion, the unemployment problem will assume structural nature and become a socio-economic problem, and a lost decade will be inevitable. I am inclined to believe that this fear too has strong justifications. However, some of the liberals policy measures are not fully supported by fact and appear to based more on hope than objective considerations.

Their hope is that aggressive fiscal and monetary actions will buy enough time for the markets to repair battered balance sheets of all parties and set the stage for a sustainable recovery. But what if it does not? The trillions of dollars so far spent on fiscal and monetary stimulus in the US had not had the expected impact (there could be a counterfactual problem here). What is the certainty that more rounds of stimulus will work? More critically, it is possible that the amount of stimulus required to make any meaningful dent is so large as to make it fiscally and politically impossible. In the circumstances, expansionary policies would be merely throwing money down the drain.

So, if the fears of inaction appear well-justified, and the possible policy alternatives are fraught with deep uncertainty, then are the developed economies set to suffer a long and tortuous period of restructuring, high unemployment and low growth? Is this the inevitable cost of the excesses that got built-up over the past decade or so? Is it desirable to have a medium-term period of de-leveraging that is necessary to wring out the excesses and distortions, rebalance balance sheets, and achieve normalcy? In the meantime, is it appropriate if public policy refrains from anything proactive (either expansionary stimulus or austerity) and confines itself to the provision of a basic minimum social safety to those worst affected by the economic weakness?

Unfortunately this approach too appears untenable. It presupposes a longer period of high unemployment rates and economic weakness. However, there are widespread concerns about its long-term impact on the labour force itself. Longer the people stay unemployed, greater the difficulty to rejoin the workforce. Skills will atrophy and productivity will decline. The socio-economic impact of this will be pernicious. The long-term impact on America's labour force and the economy in general will be damaging. See also this excellent study by Alan Krueger and Andreas Mueller.

Then there is also the danger of Japan. That country ahs been stuck in the trough for nearly two decades now and no end appears in sight. Though there are considerable dis-similarities, there are exists striking similarities - similar asset crashes, huge public debts, aging work-force, and possibly a nominal zero-interest liquidity trap. The magnitude of the downside associated with these risks are so huge that not doing anything proactive appears unwise.

In view of all the aforementioned, and given the extremity risks, inactivity may not be desirable. But there is no clarity on which strategy is most effective in stimulating a recovery. In the circumstances, the only alternative may be to throw everything at the problem and hope that some mixture of policies does enough to put the economy in the recovery path.

More on the Dark Age - overcoming the obsession with mathematical models?

John Kay argues that the fundamental challenge for economics profession today is to abandon its exclusive focus on deductive model-based approach with its focus on rigour and consistency (and expressed exclusively with the tools of mathematics) and embrace elements of real-world observations based inductivism which also draws heavily from cross-disciplinary research (which are not exactly amenable to being reduced to mathematical models). He writes,

"Consistency and rigour are features of a deductive approach, which draws conclusions from a group of axioms – and whose empirical relevance depends entirely on the universal validity of the axioms. The only descriptions that fully meet the requirements of consistency and rigour are completely artificial worlds... deductive reasoning is the mark of science: induction – in which the argument is derived from the subject matter – is the characteristic method of history or literary criticism.



But this is an artificial, exaggerated distinction. Scientific progress – not just in applied subjects such as engineering and medicine but also in more theoretical subjects including physics – is frequently the result of observation that something does work, which runs far ahead of any understanding of why it works. Not within the economics profession.



There, deductive reasoning based on logical inference from a specific set of a priori deductions is 'exactly the right way to do things'. What is absurd is not the use of the deductive method but the claim to exclusivity made for it. This debate is not simply about mathematics versus poetry. Deductive reasoning necessarily draws on mathematics and formal logic: inductive reasoning, based on experience and above all careful observation, will often make use of statistics and mathematics.



Economics is not a technique in search of problems but a set of problems in need of solution. Such problems are varied and the solutions will inevitably be eclectic. Such pragmatic thinking requires not just deductive logic but an understanding of the processes of belief formation, of anthropology, psychology and organisational behaviour, and meticulous observation of what people, businesses and governments do.



The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it."

The central challenge as the mainstream in the profession see it is to develop a model (preferably one that can be simulated on a computer) of the economy which is not only able to explain why events happen as they do but also make reasonably accurate predictions of them. Kay explores the various possible interpretations that have sought to correct the obvious flaws in the standard DSGE models, consequent to the soul-searching that followed the sub-prime crisis and its aftermath.



In response to the crititicism of the Lucasian DSGE model, its Chicago supporters have sought to make it even more complex in order for it to be more realistic! They have introduced more parameters to represent the complex problems that abound in the real world, which takes into account market frictions and transaction costs. Another response has come from those like Joe Stiglitz who while retaining many of Lucas assumptions have introduced greater importance to information imperfections (for example, Ricardian equivalence's assumptions of households having information about future budgetary problems is now questioned).



Some others, from the complexity economics school, have put forward agent-based modelling solutions, based on specific behavioural and other heuristics generally observed in the real-world. All these solutions satisfy the "requirement" of being mathematical and computer simulatable. However, questions about their real-world effectiveness remain.



Without offering any specific model, John Kay argues in favor of a less mathematics based approach. He writes,

"Another line of attack would discard altogether the idea that the economic world can be described by any universal model in which all key relationships are predetermined. Economic behaviour is influenced by technologies and cultures, which evolve in ways that are certainly not random but that cannot be fully, or perhaps at all, described by the kinds of variables and equations with which economists are familiar. The future is radically uncertain and models, when employed, must be context specific."

The crux of the debate is that all conventional approaches to explaining and forecasting macroeconomic phenomena assume that it has to be contained in a logically consistent and theoretically sound model. It assumes that it is possible to collapse all the different (and there are a maddening array of them) scenarios into this one comprehensive model.



Therefore, the supporters of the Lucasian school try to formulate a single model that can satisfactorily explain all the different types of economic recessions. Accordingly, it seeks to use the same model, with its standard set of assumptions, to explain aggregate demand slumps caused by as widely varying factors as the routine ones (say, monetary policy induced) to those spawned by banking crisis and resultant balance sheet damages.



The result is a failure to satisfactorily explain the present balance sheet recession, especially in conditions of persistent high unemployment rates and zero nominal interest rates. In response, the freshwater economists have either adopted a postion of ostrich like denial or have tried to tinker with the existing models, introducing newer parameters and assumptions to explain market frictions, and in the process drawing them further away from reality.



What if there is no such magic model that can be formulated? Is it possible to forecast macroeconomic outcomes with any great degree of accuracy, beyond estimating the broad trends? What if the degree of relevance of each assumption varies widely across different contexts, to be so irrelevant at certain times as they are relevant at other times, and in which case the model itself should assume a completely different character? More importantly, is there really a need to have a universal, one-size-fits-all model?

The counterfactual problem in public policy

Heads I win, tails you lose! This aphorism could well describe the debate on many intractable public policy issues, those where conclusive answers are difficult to come by. Supporters claim that it would have been worse without the intervention. Critics denounce the intervention as a failure since the problem persists. The challenge with all such issues is the difficulty of establishing the counterfactual. Let me illustrate this dilemma with three examples.

The most famous counterfactual problem of our times is the debate on the impact of expansionary policies implemented in the US in the aftermath of the Great Recession. Conservatives point to the persistent high unemployment rates and weak economic conditions, despite the extraordinary fiscal (more than $ 1 trillion) and monetary expansion (zero bound rates and $2.3 trillion QE), as conclusive proof of the failure of expansionary policies.

They reinforce their argument by pointing to the failure of the now infamous recovery projection, estimating future unemployment rates with and without a stimulus plan, made in January 2009 by Christina Romer and Jared Bernstein, then part of President Barack Obama's team. Their way-off-the-mark estimates suggested that unemployment would approach 9% without a stimulus, but would never exceed 8% with the plan.



In May 2011, using the latest figures available from the BLS, the unemployment rate reached 9.1%. In contrast to the Romer and Bernstein projections which estimated that the unemployment rate would be around 8.1% for May without a recovery plan, or 6.8% with a stimulus plan, the actual rate was 9.1%. The actual unemployment rate has been consistently above Romer and Bernstein’s worse case scenario for the economy – and by a considerable margin. Critics of the stimulus invoke this as proof of its complete failure. After all, though a massive and unprecedented monetary and stimulus was enacted, it appears to have had no impact in terms of improving the economic conditions.

Supporters of the stimulus in turn point to other statistics to put forward their claims about how the stimulus created employment, supported the poorest, propped up aggregate demand, and helped local governments. They argue that in the absence of the stimulus measures, the counterfactual, the economy would have plunged into a full-blown depression.

Further, economists like Paul Krugman have consistently held that the actually enacted stimulus policies have been severely deficient and have been advocating much larger doses of expansion to mitigate the high unemployment rate. In the absence of the required magnitude of expansion, they claim, it is unfair and incorrect to blame the expansionary policies for the economy languishing.

Such counterfactual problems are pervasive in economic policy making. This is especially so given the impossibility of localizing and quantifying the impact of specific policy interventions. In the circumstances, if the intervention fails to yield the desired result, critics will denounce it as a failure. Supporters will find that establishing the counterfactual, the scenario in the absence of the stimulus, is fraught with insurmountable difficulties.

Another example of such analysis is the debate about the benefits of metro-rail in New Delhi. Critics argue that despite the massive investments in the Metro, the Delhi traffic remains as bad as ever, even worse. This argument is made on the assumption that the Delhi Metro was set up with the objective of lowering traffic congestion in the city. Now that the final outcome shows no signs of traffic improvement, they argue, the Metro project has failed.

Supporters naturally point that without the Metro Delhi would been uninhabitable. They argue that the Metro has taken 1.7 million people out of the roads, and thereby ensuring that those many people stay out of city roads. They argue that the success of the Metro is a function of how many people it is able to attract and how fast its network expands. The persistent congestion is only a reflection of the fact that the Delhi traffic has been growing at a pace faster than even the growth in the Delhi Metro traffic.

Such criticisms are commonplace with infrastructure investments. They most often fail to produce tangible and immediate impact, and leaves all stakeholders unsatisfied. When the power deficit is a few gigawatts, the commissioning of a few hundred megawatts of power generation capacity has limited impact on the load-shedding situation. Similar situation arises with even major new water and sewerage treatment capacity expansion, since the requirements are massive. The problem is most acute with transportation, since traffic always appears to worsen. In the absence of any salient impact, municipal councils have no incentive to sanction scarce resources in such sectors.

Finally, the left-wing critics of economic liberalization in India point to the persisting high poverty rates and social deprivation and blame it on the neo-liberal policies of the past two decades. They argue that these policies have exacerbated social tensions, widened economic inequality, dismantled social and economic protections and therefore weakened the nation economically.

This too is a classic counterfactual problem. There are two issues here. One, serious commentators question the nature and extent of liberalization undertaken by successive governments, claiming that they have been too little and limited in scope and piecemeal and stop-start. In the absence of, leave alone the full breadth and scope, atleast even some reasonably acceptable level of liberalization, they argue, how can we blame liberalization for the current state of affairs?

Second, they argue that in the absence of this limited economic liberalization, the economy would have been in doldrums. They point to the undoubted macroeconomic gains of recent years as proof of this. How do we know what would have the state of affairs in the absence of the liberalization policies? See Ananth's excellent take on the critics of economic liberalization, including on other dimensions.

In all three cases - stimulus measures in the US, Metro railways in New Delhi, and economic liberalization in India - there is a classic cognitive bias at work, availability bias. People observe salient outcomes - the poor state of the economy, despite the stimulus spending; poor state of Delhi traffic, despite the Metro; and the persistent high poverty levels, despite economic liberalization - and conclude that these interventions failed to achieve the outcome. However, the reality clearly (albeit less so clearly in case of stimulus) points to all having had considerable effect in mitigating the respective problems, though the exact magnitude of their impacts is difficult to quantify.

Then there is another issue here. In all three cases, the opponents frame the debate by equating the particular intervention with the text-book case of the underlying concept. Accordingly, for example, they define the stimulus as was implemented in the US was the classic Keynesian stimulus, and therefore its apparent failure to get the economy out of the recession is conclusive evidence of the failing of the underlying Keynesian concept itself.

Similarly, critics' definition of the success of metro rail as measured by the resultant reduction in congestion rate, means that an actual increase in congestion is taken as proof of its failure. For neo-liberal critics, Manmohanomics is the embodiment of economic liberalization and since it did not "eliminate poverty", as promised, it has failed!

Early warning indicators missed in Europe

Arguably the most important lesson from the sub-prime mortgage meltdown and the consequent Great Recession is that regulators and policy makers across the board either failed to spot or, if they did, ignored early warning signals of impending problems. Post-facto analysis has revealed ample and clear distress signals across many markets on which regulators and policy makers should have acted on.

As Floyd Norris writes by pointing to the examples of Spain and Ireland, more critical and objective analysis of national macroeconomic data could have given out clear indicators of the crisis ahead. Just five years back, both these countries were the star performers among all Euro zone economies with the highest GDP growth rates and lowest fiscal deficits and debt-to-GDP ratios.

However, as the graphic below shows, this rosy picture masked concerns about the unsustainable debts the private sector in these (and Greece and Portugal) were piling up. These borrowings were fueling rapid economic growth that, in turn, produced rising tax collections, allowing national governments to run budget surpluses. The big problem was that instead of going to productive capital investments, this money was finding its way into the property market, fuelling an unproductive property bubble across these countries.



When the crash came private excesses got nationalized and got converted to public sector debt. The massive bailouts of beleaguered financial institutions, fiscal stimulus spending to prop up the recessionary economy, and the slump in all tax revenues ended up devastating the government fiscal balances.

The financial market regulators clearly failed in their responsibility of broad management of the process of capital allocation. The end-use patterns of these external private capital inflows would have been very clear for anybody who cared to observe. But regulators turned the other way.

Bubbles make a mockery of the rational economic man hypothesis among all stakeholders, even regulators. Regulators living through a bubble have always given the impression of being carried away by its "irrational exuberance" and the feeling that the party will go on forever. Then there is the issue of nobody wanting to "take the punch bowl away when the party is on". How do we know that we are not nipping a new growth cycle in the bud?

But all these instincts flies in the face of all standard macroeconomic and financial market theories. There is ample historical evidence, supporting theories, to show how such distress signals could be forebodings of crisis ahead, if not appropriately addressed. It is a constant theme from history that if private sector deficits reached the levels of Spain, Protugal and Ireland, and they were going into fuelling a bubble, then a debt crisis is not far away. Why did regulators think that "this time is different"?

Does this mean that we need to have exclusive arms within the regulatory and policy making appratus whose main job is to exclusively look for the danger signs and act as devil's advocates? Risk managers in private financial institutions are mandated to do precisely this job for their firms, but failed spectacularly. Can we expect anything different from such managers within government regulatory and policy making machinery?

In any case, spotting early warning signals, dissseminating them widely in a cognitively salient manner, and triggering off actions to mitigate these indicators of distress are arguably the most important areas of work for academics, risk managers, regulators, and policy makers.

Mapping and disseminating the risk topography

It is now widely acknowledged that arguably the biggest contributor to the sub-prime financial market crisis was a failure to anticipate and act on the build-up of risks across the sector. This constitutes failures at two levels - having access to information on the evolution of various cross-sectional risks with time and then acting appropriately to mitigate these emerging risks.

Robert Shiller points to a 2010 paper by Donald L. Kohn, Matthew J. Eichner and Michael G. Palumbo, who argue that the underlying themes were similar to previous crises,

"Although the instruments and transactions most closely associated with the financial crisis of 2008 and 2009 were novel, the underlying themes that played out in the crisis were familiar from previous episodes: Competitive dynamics resulted in excessive leverage and risktaking by large, interconnected firms, in heavy reliance on short-term sources of funding to finance long-term and ultimately terribly illiquid positions, and in common exposures being shared by many major financial institutions."

Taking cue from this, they point to the need for policy makers to have "better and earlier indications regarding these critical, and apparently recurring, core vulnerabilities in the financial system". In particular with the sub-prime crisis, they point to two information failures. One was the failure to anticipate "the underlying credit risk associated with the rapid growth of home mortgages and a consequent increase in the vulnerability of borrowers to a downturn in home prices or incomes". The other was the inability to assess the growth of financial vulnerability outside the traditional banking sector because of "a greater reliance on short-term funding for longer-term financial instruments". They emphasise the need to fill up these data gaps and have real-time information on them to have a comprehensive early warning system in place.

The authors also argue that merely collecting data, even analyzing them, would not serve much purpose. It is critical that the analysis focus on the relevant areas - specific instruments and their transactions - and then it should be rendered in the most effective manner to evoke the desired response among all the relevant stakeholders. In this context, as a large number of researchers have argued, the presence of automatic stabilizing mechanisms (like say, dynamic capital buffers and reserve requirements) can eliminate the risk of stakeholders not acting (for whatever reasons) even when faced with information on emerging risks. They write,

"More fundamental, in our view, is the need to use data in a different way — in a way that integrates the ongoing analysis of macro data to identify areas of interest with the development of highly specialized information to illuminate those areas, including the relevant instruments and transactional forms... We can easily imagine specifying ex ante a program of data collection that would look for vulnerabilities in the wrong place, particularly if the actual act of looking by macro- or microprudential supervisors causes the locus of activity to shift into a new shadow somewhere else."

In this context, in a recent working paper, Markus K. Brunnermeier, Gary Gorton, and Arvind Krishnamurthy have sought to identify the kinds of risk measurements of leverage and liquidity that should be collected and how it should be interpreted in terms of modern financial theory to provide real-time decision support for financial market participants. They conceptualize and design a risk topography that outlines a data acquisition and dissemination process that informs policymakers, researchers and market participants about systemic risk. They write,

"Our approach emphasizes that systemic risk (i) cannot be detected based on measuring cash instruments, e.g., balance sheet items and income statement items; (ii) typically builds up in the background before materializing in a crisis; and (iii), is determined by market participants’ response to various shocks. We propose that regulators elicit from market participants their (partial equilibrium) risk as well as liquidity sensitivities with respect to major risk factors and liquidity scenarios. General equilibrium responses and economy-wide system effects can be calibrated using this panel data set."

This is one such excellent data reresentation technique that maps the build-up of co-related risks. HSBC researchers use heat maps to identify the changes in correlations between different categories of asset classes.

Back to square one - financial market regulation?

The bitter lessons of the sub-prime crisis appears to be slowly receding away from memory and the unhealthy practices that inflated the sub-prime bubble era are returning back with vengeance. Now that the markets are back to normal, atleast in appearances, the urge to return to the boom days is proving irresistible.

The latest evidence comes from the US Federal Reserve’s recent decision to allow major banks to increase their dividends and to buy back shares. The decision comes in the aftermath of the Fed's Comprehensive Capital Analysis and Review (CCAR), a cross-institution study of the capital plans of the 19 largest US bank holding companies.

In an excellent post, Simon Johnson has strongly contested this decision and the validity of the CCAR to reliably assess the strength of banks

"The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged... Bank executives and other key personnel are paid on a "return on equity" basis, so this increases their upside — that is, what they will make as long as the economy and their sector does well... Any individual bank will want to keep its equity levels low, because its executives and owners are not worried about system-wide spillover costs, such as what happens to other banks when one bank fails."

The failure risk for big banks is mitigated by the blanket insurance provided by the too-big-to-fail problem - governments cannot allow such institutions to sink for fear of a financial market meltdown. The bank executives, creditors, and even shareholders, all suffer from the moral hazard problem arising from this.

In a letter to the Financial Times, Anat R Admati and her colleague financial academics, had this to say about dividend payouts and share buybacks,

"A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress. For this reason, and to prevent the shifting of value from debt holders to equity holders, debt covenants typically restrict dividend payments when leverage is high... taxpayers should be concerned when banks pay dividends and remain thinly capitalized, because, as we have seen, taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis... retaining earnings is generally viewed as the least costly way to raise funds and build capital, as it avoids the transactions costs associated with new equity issuance."

This debate revolves around one of the most fundamental problems in modern financial markets - who will bear the cost of addressing the systemic risks (with its massive negative externalities) that are generated by certain actions of banks, what should be that cost, and in what form should it be levied?

The sub-prime crisis has drawn attention to the dangerous consequences of excessive risk-taking and leverage, and the systemic risk created by too-interconnected to fail big financial institutions (the TBTF problem). The tax payers had to bear the burden of the massive amounts required to bailout financial institutions in the aftermath of the bursting of the mortgage bubble. It is therefore universally accepted that these financial institutions have to internalize the cost of addressing the systemic risks generated by their actions.

It is widely acknowledged that adequate equity capital and reasonably high enough counter-cyclical risk weighted capital reserves are necessary to meaningfully resolve these problems. The global banking regulators recently announced the Basel 3 regulations in an effort to mitigate the systemic risks that arise in the financial markets. However, a large number of influential financial economists have argued that the capital reserves required to address such risks are much higher than what is proposed under the Basel 3.

In an excellent NYT article Gretchen Morgenson points to a few other instances of attempted regulatory dilution as the Dodd-Frank Law becomes operational. These measures are being pushed by taking the cover of getting the securitization, derivatives and the mortgage market moving again and to buoy falling home and other asset prices.

One of the biggest achievements of the new legislation was to route all derivative trades through clearing houses and exchanges. However, now bankers are calling for exempting currency swaps from Dodd-Frank citing a provision that permits the Treasury secretary to exempt foreign-exchange swaps from the regulation. Foreign exchange swap trades are in the range of about $4 trillion a day, and trading in foreign-exchange contracts generated revenue of $9 billion in 2010 in the top five US banks, more than was produced by any other type of derivative.

Critics say that the only the only reason this market did not seize up like others during the meltdown was that the Fed lent huge amounts — $5.4 trillion — to foreign central banks through so-called swap lines during the fall of 2008. However, the Treasury Secretary Tim Geithner looks inclined to providing the exemption.

There are details of interpretation of specific provisions in the Dodd Frank law that could determine whether the relevance or otherwise of the regulation. One concerns how regulators define a 'qualified residential mortgage'. Morgenson writes,

"Issuers of asset-backed securities that are made up of such loans needn’t keep any credit risk of those securities. But sellers of loan pools that don’t consist of qualified mortgages are required to retain some of the risk in them. This provision was meant to eliminate the perverse incentives of the mortgage boom, when packagers of loan pools were encouraged to fill said pools with toxic waste because they had little or no liability for the deals once they were sold.

What constitutes a qualified mortgage has become a battleground issue because of the risk-retention rules under Dodd-Frank. Qualified mortgages should be of higher quality, based upon a borrower’s income, ability to pay and other attributes to be decided by financial regulators... Among the questions to be considered is how much of a down payment should be required in a qualified loan, and whether mortgage insurance can be used to protect against the increased risks in loans that have smaller down payments.

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured. But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans.Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington."

She also points to the battle to re-open trade on covered bonds - pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets, while the issuing bank retains the credit risk. The problem with this is that since the investors who bought the covered bonds would have first call on the banks' assets (over that of the FDIC), this would wind up bestowing a new form of government backing (FDIC's deposit insurance) to the major banks issuing the bonds.

And confirmation that things are indeed getting back to normal comes from the graphic below of financial sector (it accounts for less than 10% of the value added in the economy) profits, which have regained its pre-crisis share and is back to more than 30% of all domestic US profits



Felix Salmon should have the last word,

"Banks are still extracting enormous rents from the economy, and profits which should be flowing to productive industries are instead being captured by financial intermediaries. We’re back near boom-era levels of profitability now, and no one seems to worry that the flipside of higher returns is higher risk. Any dreams of seeing a smaller financial sector have now officially been dashed. And the big rebound in corporate profits since the crisis turns out to be largely a function of the one sector which we didn’t want to recover to its former size."

Re-thinking macroeconomic policies - a graphical summary

The sub-prime mortgage crisis and the Great Recession have questioned several underlying assumptions of modern macroeconomics. Paul Krugman famously called it the "Dark Age of Macroeconomics" and many standard macroeconomics text books are currently undergoing wholesale revisions in the light to these experiences.

What should be the role of Central Banks, especially in ensuring financial stability? What are the policies and instruments that can be deployed by central banks? What should be the optimal inflation target? What are the exit routes available for central banks from extraordinary monetary accommodation? Do central banks have a role in stabilizing output, that goes beyond interest rate changes, especially when faced with deep recessions?

What regulations are required to ensure greater stability and improve the crisis-resilience of banks? What can be done to contain the build up of systemic risks and limit the contagion effects of deleveraging and resultant liquidity crisis? How do we mitigate the moral hazard concerns arising from financial bailouts? What type of financial market regulations are required to limit the possibility of asset bubbles?

What are the fiscal policy options for governments faced with an economic recession and zero-bound in interest rates? How should fiscal policy be organized during such recessions? Which policies deliver the greatest bang for the buck? How can we swiftly deploy stimulus measures in the face of political paralyses and gridlocks? Should governments restrain from stimulating the economy, when faced with zero-bound recessions, with short-term fiscal measures for fear of deficits and debts?

What is the role of global macoreconomic imbalances in causing and sustaining asset bubbles? What is required to prevent the build up of such imbalances? How should cross-border financial flows be regulated? What is the optimal capital account policy for emerging economies? What sort of international monetary system is required to satisfactorily resolve cross-national financial crises?

I have tried to consolidate the learnings from events of the last three years and the post-mortems and other research that has gone into more satisfactorily understanding and explaining macroeconomic policy making. The result is this graphic. While I must admit that it is highly simplified (all such beautiful flow-charts are meant to simplify complex policy eco-systems), it only seeks to broadly highlight all the different elements of a post-crisis macoreconomic policy framework.

It is clear that the mandate of central banks have to expand beyond inflation targeting and include financial market stability. And when faced with deep recessions, central banks have a credit policy role, whence it could become a lender, buyer, and insurer of last resort. Fiscal policy becomes critical when monetary policy loses traction and when interest rates are at the zero-bound. Its main instruments are automatic stabilizers and discretionary spending measures. The specific instruments of each policy, as indicated in the chart, are illustrative and is meant to merely guide discussion.



(Please click on the graphic to enlarge)

In fact, the IMF recently brought together some of the world's leading economists to a conference where the Fund and participants urged a wholesale re-examination of macroeconomic policy principles. See also this concise presentation by Olivier Blanchard.

The trans-Atlantic debate on igniting economic recovery

When history of the Great Recession will be written, among the primary issues for discussion will be the relative impacts of recovery policies followed across countries.

On the one hand, countries like England, Estonia and Ireland have responded with savage fiscal austerity by cutting wages, spending, and even raising taxes. Across the Atlantic, the US has responded with multiple fiscal stimuluses and continuing monetary accommodation. The major European economies like Germany and France too reacted with stimulus measures, albeit much less muted. Which of these two opposing fiscal policy stances succeeded?

There are two undoubted distinguishing features of the Great Recession. One, aggregate demand has slumped as evidenced by persistently weak consumer spending and the rise in unemployment rate. Second, the balance sheets of households and businesses have been battered by the bursting of the asset bubbles.

Both require different policy prescriptions. An aggregate demand slump would require fiscal policy interventions that would provide money to those people who are likely to spend them. Direct spending measures (like infrastructure works and transfers to local governments) and social safety cushions (like unemployment insurance and food stamps) are ideal for boosting aggregate demand.

Repairing battered balance sheets require policies that help pay off debts or lower its burden or atleast reschedule them. Monetary accommodation for an extended period will lower the debt service burden. Additional credit lines will help mitigate the inevitable liquidity contraction after a financial market meltdown. Since large numbers of people are left with negative housing equity, policies that restructure mortgage debts will help repair household balance sheets. Stimulus spending by way of tax cuts will leave people and businesses with more money which can be used to repay debts.

However, balance sheets cannot be repaired in a hurry. In fact, it will take long for households and firms to shake off the massive debts accummulated. It can only be hoped that some or all of the aforementioned policies work towards helping regain much of the lost ground in asset values. In other words, policies aimed at repairing balance sheets will involve both direct efforts to reduce debt burden and indirectly buy time so that recovery will itself contribute to rebuilding balance sheets.

Both features weigh heavily on the US, British, and Irish economies - aggregate demand is weak and balance sheets of both households and financial institutions are bruised. In addition, government debts too have crossed sustainable levels. But the situation is different with much of continental Europe. They did not experience the same sort of property market bubbles like in the US or Ireland. Accordingly, household balance sheets are less a problem. Their problems lie in financial institutions with massive exposure to their own peripheral economies (the PIIGS).

In case of the PIIGS, all the three - governments, businesses and financial institutions - face deep struggles. All of them borrowed and splurged heavily during the boom and are now facing pay-back time. There is limited fiscal space available for any meaningful stimulus spending. The fiscal austerity, under implementation in some form of the other in all of them, is taking its toll on citizens.

Whatever the specific details of the policies being followed, an immediate return to robust economic growth is critical to the fortunes of all these economies. Strong growth is necessary to not only reduce the high unemployment rates, but more importantly to ensure that the share of public debts do not explode and trigger sovereign defaults.

In the circusmtances, fiscal austerity will leave the entire recovery burden on the private sector. It will have to generate enough growth to not only kick-start growth, but also cover for the loss in GDP due to fiscal contraction. And it will have to achieve this in conditions marked by persistent financial market uncertainty (with resultant high cost of capital), bruised (business and banking) balance sheets, and citizens who will face the brunt of the government's spending cuts. The odds of succeeding against these very formidable obstacles are minimal.

The initial indications from the British experience with fiscal austerity has been disastrous. After four consecutive quarters of modest growth, the economy experienced a contraction in the last quarter of 2010, declining 0.5%. This comes in the back of an extraordinary $128 bn four-year program of spending cuts and tax increases, including an across-the-board reduction of 20% in the budgets of most government departments. Ireland's two year fiscal austerity appears to be leading the country firmly down the sovereign default path. If that is any indicator, England faces a very long and painful struggle ahead.

However, there is one area where the debate about policy responses appears to have been settled. In the aftermath of the sub-prime meltdown, the US Fed and Government responded with great speed and pumped in massive amounts of liquidity to bailout the affected financial institutions. Apart from lowering interest rates to the zero-bound, these measures also included credit guarantees and unconventional quantitative easing through direct credit injections, banking reserve expansions, and asset purchases.

The Fed emerged as an effective lender and insurer of last resort. A massive $750 bn financial market bailout was followed by two rounds of quantitative easing. More than $3 trillion have beeen injected into the financial markets to drive Wall Street's recovery. And the results have been spectacular, though confined to corporate America.

Simon Johnson places the recovery in Wall Street and corporate profits in the US in perspective by comparing with recoveries in earlier recessions. The last quarter saw Wall Street back to pre-crisis levels of profits and executive compensation. The bailouts and implicit government guarantees saved the day for Wall Street. The fiscal stimulus backstopped corporate profits from falling too much. The ultra-low interest rates have kept the debt service burdens low and bought time to heal the debt-laden balance seets. He writes,

"Profits for the private sector... in the third quarter of last year... were back at the level of 2006. After the deep recessions of the early 1980s, it took at least three times as long for profits to come back to the same extent."

He also writes,

"In the back-to-back recessions of 1980-82, real non-financial sector profits dropped about 30% (from 1977-78 to 1980) and struggled to rebound for most of the decade. This same measure of profits did not surpass its level of the late 1970s until the early 1990s... during that same cycle... real profits in the financial sector fell 50% from 1979 to 1980, regaining the level of the late 1970s by 1987...

In contrast, over the finance-led boom-bust-bailout cycle of 2007-2010... profits have proved much more resilient. In real terms, the financial sector earned record profits in 2005 (and accounted for an eye-popping 30% of total corporate profits in that year). These fell sharply, to be sure, but only really for one quarter at the end of 2008. Financial sector profits have been running at around 90% of their pre-crisis level since early 2009."

Iceland Vs Ireland?

Almost alone among those who faced the depths of the financial crisis, Iceland refused to bailout its financial institutions. It placed its biggest lenders in receivership and chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion (11 times GDP). In other words, the creditors, not the taxpayers, shouldered the losses of banks.

The krona lost 58% of its value by the end of November 2008, inflation spiked to 19% in January 2009 and GDP contracted by 7% that year. The Prime Minister Geir H. Haarde resigned after nationwide protests.

As a Bloomberg report argues, if early signs are any indicator (with economy projected to grow 3% in 2011), then Iceland’s decision to let the banks fail is looking smart and may provide important lessons for others. The GDP grew for the first time in two years in the third quarter, by 1.2%, inflation is down to 1.8%, the cost of insuring government debt has tumbled 80%, and banks have bounced back into the profitability.

The three biggest Icelandic banks - Kaupthing Bank hf, Landsbanki Islands hf and Glitnir - who had indulged in the spectacular lending spree at home and overseas were seized by regulators on October 6, 2008. The Bloomberg report writes,

"The government negotiated with the creditors, almost all of them outside the country, including mutual funds and hedge funds in the US and the UK and European banks and pension funds. Kaupthing’s creditors agreed to take an 87% stake in Arion, and Glitnir’s creditors now own 95% of Islandsbanki. Glitnir’s biggest creditor as of June was Dublin- based Burlington Loan Management Ltd., followed by Royal Bank of Scotland and DekaBank Deutsche Girozentrale, the fund manager for Germany’s state-owned savings banks.

Glitnir’s 8,500 creditors and Kaupthing’s 28,000 expect to get about 30 cents on the dollar for their claims, based on secondary-market prices of the banks’ debt and asset valuations by the resolution committees. About half of Kaupthing’s creditors are German depositors who had Internet accounts, have gotten their principal back and are seeking interest payments.

Landsbanki’s creditors opted for a promissory note from successor NBI hf instead of a stake in the new bank. Landsbanki had collected about $5 billion of overseas deposits through branches in the U.K. and the Netherlands. Iceland didn’t guarantee those deposits at the time it seized the bank, as it did for domestic customers, leading to a dispute with the British and Dutch governments. In December, Iceland agreed to compensate the U.K. and the Netherlands in full for their payments to Icesave depositors, as the Landsbanki accounts were known. Payment, including interest of about 3 percent, will be made over 35 years."

In contrast, Ireland guaranteed all the liabilities of its banks when they ran into trouble and has so far injected 46 billion euros ($64 billion) as capital so far to prop up these banks. The result is an unsustainable debt burden that could swell to twice its GDP, up from 94% now and the near certainty of a sovereign debt default. It is a widely held feeling in Icleand that if it had guaranteed all the banks’ liabilities, they would have been in the same situation as Ireland.

See this Vanity Fair article by Micheal Lewis on Ireland. Micheal Mandel has an excellent series of graphics that puts the role of external sector, exports/imports and financial profit repatriations, on Ireland's economic fortunes in perspective.