But perhaps more important than when to exit is the question of how and whether indeed it will be so easy and simple for central banks to simply wind down the supply of medicine. In the context of the ECB for example, I remain rather sceptical.

However, this day is all about the Fed decision  and although I only rarely delve into account of US monetary policy decisions (comparative advantage you know!) this one is important since it was always going to be parsed very closely for signs of hawkishness on rates on the one side as well as indications of the future wind down of asset purchases. Now, for those who expected a big bang, I have to side with Macro Man that it seems to be much ado about nothing in the sense that the Fed basically reiterated the general view that although economic activity had been showing positive signs lately and especially in the context of leading indicators pointing to a strong bounce in Q3 and Q4 activity, the fundamentals of very low capacity utilisation and deleveraging across the real economy remain intact. In the context of Fed speak this translates into maintaining the current rate target at the zero bound and the the forward looking statement that rates are to kept low for an extended period; 

Conditions in financial markets have improved further, and activity in the housing sector has increased.  Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.  Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.  Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.  The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

So far so good then and this was really all we needed, one would imagine, to extent the rally in risky assets as well as the downward trend in the USD as the new funding currency for carry traders and others of their ilk. So far, there has been no signs of panic anywhere and everything seems to be all engines go.

Meanwhile, the Fed did actually give away some details as to how the future bout of asset purchases are to be conducted. On the matter of treasury purchases the Fed will its total purchase of $300 billion by the end of October. Most of us would naturally like to be able to predict what this will to do yields and prices and really you could spin this two ways. In the context of supply side worries, the Fed's withdrawal from the treasury market should push down yields if we add the, perhaps dubious assumption, that the $300 billion worth of supply of treasury bills has only been there to the extent that the Fed has been the main bidder (Say's law and everything). On the other hand it could also push up yields in a world where one assumes that there has been a decisive need to issue such bills and now that the Fed is stepping aside new buyers must step in and notwithstanding those with a printing press of their own, it should push up yields. Although this may seem quite innocuous and technical (i.e. unimportant) it may turn out to be important in a general context when it comes to the ability of economies (not just the US) to lift themselves out of the mire without the crutches of stimulus to lean on.

In the context of the Fed's outright asset purchases, the statement delivered good news for bulls/doves in so far as goes the fact that although the Fed was invariably going to issue a deadline, it seems to have been pushed somewhat out in the distance; well, at least a quarter. Consequently, the Fed will buy $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt, purchases which are set to be concluded by the end of the first quarter and not by year end which was the final date I had been led to believe judged by the points made in various economics report digested over the last week.

So, it is here perhaps that we may be looking at a disappearing bid in the context of the Fed gradually but surely reducing its presence in the market for MBS turds not to mention the agency market which went belly up as Fannie and Freddie crashed and burned. In the nice soothing light of efficient markets it is difficult to expect the decision to wind down purchases to be a big market mover as long as the incoming bout of data continues to provide plenty of upside and no downside. But if we get a setback just around the time when the Fed had envisioned to stand down its most aggressive measures of QE, one finds it difficult not to expect general sentiment and thus, in a forward looking perspective, real economic activity to take a hit which is exactly what we would all like to avoid; the double dip recession or "WL" recession if you will.

Ultimately, it is of course all still a great big mess, something which was neatly conveyed by the way Bloomberg handled the message carried by the IMF envoy to the G20 summit. On the one hand, the IMF was quoted for urging central banks to map a viable and transparent exit strategy and on the other hand Managing Director Dominique Strauss-Kahn was quoting for urging policy makers to not withdraw fiscal stimulus to quickly. Lost in translation are we?

Well, I am perhaps being unfair here to the editors of Bloomberg not to mention the IMF in particular since ultimately; talking about exit strategies is not the same thing as enforcing them. However, I do feel rather strongly about the need to make the following point that the two are of course intimately connected and withdrawing QE cannot but affect the trajectory of fiscal stimulus. This is a point which I believe for example is absolutely crucial to understand in the context of the Eurozone where the ECB's refinancing operations seem to be implicitly underpinning national governments' efforts to shore up their capsized economies.

In this context and assuming that both the BOJ and the ECB will be trailing the Fed somewhat, it will be most interesting to see whether Bernanke manages withdraw the bid on financial markets currently offered by the Fed's policies and indeed whether others may follow in his footsteps and withdraw theirs.

More from Bill in The Daily Reckoning:

Deflation? What does that remind you of, dear reader?

Japan! Of course. This is the trend your editor saw coming 10 years too soon — a Japan-like slump.

“A deep and prolonged recession could raise the spectre of deflation of the sort that long plagued the Japanese economy,” says a fellow at the American Enterprise Institute.

“Welcome to Hiroshima, mon amour,” was how we put it, with Addison Wiggin, in our 2003 book, “Financial Reckoning Day.”

“If the…

More from Whiskey & Gunpowder:

There are only two things gold bulls should worry about from this point forward, now that the general commodity correction is out of the way and the froth has been worked out of the market: deflation in the strict sense of the term (monetary, not asset deflation) or a suddenly brightening economic outlook, both of which, in this writer’s…

“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

"Herd behavior occurs when people do what others do rather than rely on their own (incomplete) information, which might be suggesting something different (Banerjee, 1992). The suppression of private information could lead to “information cascades” when decisions are made sequentially and a large enough number of people choose identical actions. In such settings, the decisions of a critical few people early on are enough to tilt group behavior toward a certain direction. Mimicking the behavior of others might be rational because of uncertainty about one’s own information as well as the need to economize on information-gathering costs. Rational herd behavior is the subject of a recent strand of behavioral finance (see Montier, 2002, for an introduction). "

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.


The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.


Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References On Swiss Franc Loans and "Translation"

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Balance Sheet Consequences: The Academic Research


Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention - at least among theoretical economists) is that of the so called "balance sheet consequences" of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

In the paper which follows Krugman sketches out yet another candidate for third-generation crisis modeling, one that emphasizes two factors that had been omitted from previous formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate. The model was at that point (and as Krugman himself says) quite raw, with lots of loose ends hanging about. However, it did seem to tell a story with a much more realistic “feel” than some of the earlier efforts. It could be hoped that now that he has had time to recover from the shock of his recent Nobel, he may get interested once more in this earlier centre of his attention, since the model badly needs updating, and in particular to take account of the shift in the risk away from the corporate and towards the household balance sheet.

Balance Sheet Effects, Bailout Guarantees and Financial Crises
MARTIN SCHNEIDER UCLA and AARON TORNELL UCLA and NBER

This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.


In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

And please note the last sentence: "lenders are bailed out if a critical mass of borrowers defaults", this, I imagine, is what we are about to see happen next.

A Balance Sheet Approach to Financial Crisis
Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini :

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.

“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

"Herd behavior occurs when people do what others do rather than rely on their
own (incomplete) information, which might be suggesting something different
(Banerjee, 1992). The suppression of private information could lead to
“information cascades” when decisions are made sequentially and a large enough
number of people choose identical actions. In such settings, the decisions of a
critical few people early on are enough to tilt group behavior toward a certain
direction. Mimicking the behavior of others might be rational because of
uncertainty about one’s own information as well as the need to economize on
information-gathering costs. Rational herd behavior is the subject of a recent
strand of behavioral finance (see Montier, 2002, for an introduction). "

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.


The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.


Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References On Swiss Franc Loans and "Translation"

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Balance Sheet Consequences: The Academic Research


Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention) - at least among theoretical economists) is that of the so called balance sheet cosnequences of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

In the paper which follows Krugman sketches out yet another candidate for third-generation crisis modeling, one that emphasizes two factors that had been omitted from previous formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate. The model was at that point (and as Krugman himself says) quite raw, with lots of loose ends hanging about. However, it did seem to tell a story with a much more realistic “feel” than some of the earlier efforts. It could be hoped that now that he has had time to recover from the shock of his recent Nobel, he may get interested once more in this earlier centre of his attention, since the model badly needs updating, and in particular to take account of the shift in the risk away from the corporate and towards the household balance sheet.

Balance Sheet Effects, Bailout Guarantees and Financial Crises
MARTIN SCHNEIDER UCLA and AARON TORNELL UCLA and NBER

This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.


In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

And please note the last sentence: "lenders are bailed out if a critical mass of borrowers defaults", this, I imagine, is what we are about to see happen next.

A Balance Sheet Approach to Financial Crisis
Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini :

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.

The crash in stock prices has most investors spooked. But it's worth keeping you head while others lose theirs, says Strategic Investment editor Dan Amoss.

Right now, there are some very healthy resource stocks are shockingly cheap. What Dan calls "screaming bargains."

This from Whiskey and Gunpowder:

It amazes me how long this environment of panic has lasted.

Last Thursday was one of the most violent days I’ve ever experienced in the markets, including the bursting of the tech bubble. Quality companies in the oil services, coal, steel, and agriculture sectors were liquidated in violent fashion — many of them down 20% in a day and 50% over the past month.

These are real companies performing vital functions necessary to keep the lights on and food on shelves, not speculative internet stocks.

The list of victims includes companies that are very likely to deliver good earnings over the next few years. The list includes several of the stocks I’ve recommended in past issues of Strategic Investment, and still follow closely.

If you’re a long investor, there are some screaming bargains out there — unless, of course, half of the world’s population stops using food, electricity, and oil. I doubt that will happen in a world of unfettered deficits and central banks, but anything’s possible. I’ll have more to say about this in an upcoming issue of Strategic Investment.

For immediate ideas, I strongly recommend considering the long list of bargains that my colleague Chris Mayer has recommended in Capital & Crisis and Mayer’s Special Situations.

It’s mind-boggling how cheap some of them have become. Chris is an excellent stock picker. He goes to great lengths to find safe, cheap investments.

The money managers that survive this environment will probably look to own some of the dirt-cheap stocks in the energy, commodity, and agriculture sectors, rather than expensive stocks that thrived on spending from home equity loans.

Once this credit market panic subsides, I expect we’ll see this shift in sector focus.

Fund managers will have to start distinguishing between earnings that resulted from fake, bubble-induced consumption, and earnings that resulted from real, sustainable demand.

I’m looking forward to earnings season, when analysts and fund managers can finally get some guidance about which companies’ earnings will hold up best during this recession.

Even the best fund managers and stock pickers in the world are down for the year. A few of these managers saw the credit crisis coming, and made nice profits shorting financial stocks. But the SEC’s totally arbitrary rule changes in recent weeks have created an environment that’s very difficult to navigate.

The SEC’s short selling ban has not changed much, other than taking efficiency and liquidity out of the market. For example, Allied Capital was on the “do not short” list. Yet it crashed earlier this week upon announcing the bankruptcy of Ciena Capital. That was a case of long investors all trying to squeeze out of a narrow door of liquidity. It was not a “short attack.”

Uncertainty about the banking system is causing this panic in the credit markets. Innocent bystanders are suffering from the fallout from this credit bubble.

For example, I’ve read several accounts of hedge funds whose assets are stuck in the black hole that is Lehman Brothers’ balance sheet.

I’m not referring to people who own Lehman bonds, I’m referring to funds that had custodial agreements with Lehman. Custodial agreements are supposed to ensure that Lehman could only execute trades for the pool of assets under its custody — not take actual possession of the assets.

It seems that in the days and hours before declaring bankruptcy, Lehman moved certain assets — many of which it did not own — to its subsidiaries all around the globe. Now, hedge funds with no perceived credit exposure to Lehman are joining the line of creditors, fighting to get their clients’ assets back in bankruptcy court.

This total destruction of confidence in counterparty risk is the reason why credit is drying up. So what has the Federal Reserve been doing as the lender of last resort?

It has nearly doubled the size of its balance sheet in the past few weeks. The Oct. 3 issue of Grant’s Interest Rate Observer describes:

“After a flat-footed start, [the Fed] had shown its ability to degrade its balance sheet by selling off its Treasuries and acquiring dubious mortgages. But it had not really put its back into dollar debasement. The sum total of its earning assets, i.e., Reserve Bank credit, was rising at year-over-year rates of just 3% to 4%. Where was the push to print up enough dollar bills to smother the debt crisis of 2007-8 — assuming the problem was susceptible to smothering through money printing?

“Mystery solved: Reserve Bank credit is suddenly flying. It surged by $203.6 billion, to $1.135 trillion, in the banking week ended Sept. 24. And if Merrill Lynch’s guess is on the mark, it has soared to $1.730 trillion in only the past few days, a near doubling since May 2007 [emphasis added], when the latent crisis became manifest.”

After the panic subsides, the Fed will rein in much of this new money.

Right now, banks are “stuffing it under the mattress,” so to speak. Banks and individuals are crowding into the perceived safety of Treasury bonds. That’s why consumer prices aren’t immediately rising; private market credit is contracting as fast as the Fed’s balance sheet is expanding.

The Fed will always lend when no one else is willing to do so. “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost,” said Fed Chairman Bernanke in November 2002. This means that there will always be paper money available to lend. However, the U.S. dollar is getting debased on an unprecedented scale.

~~~~~~~~~~~~~~~Special~~~~~~~~~~~~~~~

“Bailout” Ben Bernanke may be set on destroying the value of your savings, but you don’t have to stand for it.

A lot of Americans are already seeing their hopes dashed as the credit bubble deflates and the wealth they thought they had in stocks and real estate disappears.

It will get a lot worse for them when they find their dollars only buying half the food and fuel they used to.

Don’t be fooled by the dollar’s recent surge… the fix is in thanks to the Fed. Devaluation is inevitable. Make sure you protect your savings before it’s too late.

Read this special report for details…

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

The printing press may be the only way to prevent a self-sustaining credit panic, but it doesn’t come without a price; it lowers the U.S. dollar’s stature even further in the eyes of our foreign creditors.

I’m betting that government inflation will defeat private market deflation.

However, when the dust settles, I expect the Treasury and Fed to have its own set of negotiations with foreign creditors. The obligations they are assuming and monetizing are simply too enormous without inciting a potential panic among our generous foreign creditors. Maybe we’ll see a Bretton Woods-type agreement in 2009 — one where the U.S. dollar is devalued by 50% against certain foreign currencies overnight.

Source: A Few Great Apples

They still believed that the stock market was going to produce 15% per annum returns for the foreseeable future. September 2008 and he ended that mantra. On September 3, the Dow Jones Industrial Average was where it had been at its peak in 2000: 11,700. The Standard & Poor's 500 index was lower: 1280 vs. 1529 (close). Subtract from that over 20% price inflation.

The experts on CNBC on September 1 still clung to the illusion that there was no recession, the boom was still in
force, and everything would work out just fine. By the end of September, all that lay in ruins. There is no optimism on CNBC today. There is a kind of stiff upper lip determination not to panic.

It should have been obvious in August 2007 that the end of post-2003 stock market recovery was over. Bernanke had tightened money from the day he took over as chairman of the Board of Governors of the Federal Reserve system in February 2006.

Real estate was the driving force of the expansion, and real estate was in decline. It was obvious to me in late 2005 that the bull market in real estate was over. I said so at the time. It was surreal estate. A handful of us saw this coming, but it seemed so far-fetched at the time that virtually nobody paid any attention. They now pay attention.

Real estate from 2001 to late 2005 was the largest bubble in American financial history. It dwarfed the bubble of the stock market in the 1920s, because that bubble had involved only a tiny fraction of American investors. The residential real estate bubble involved two-thirds of the population, all of whom owned homes. The other third were affected because of rising rents.

People thought that they were going to get rich with leveraged real estate. Instead, something in the range of 40% of all mortgage debtors in the United States will be under water in their mortgages by the end of 2009. People were told by the experts that "this time it's different." It wasn't different. It was just more extreme. The consequences will be felt over the next decade.

In September, confidence was at long last shattered. At the beginning of the month, Secretary of the Treasury Henry Paulson was still assuring people that the banking system was perfectly sound. On Sunday, September 7, he unilaterally announced the Federal government was taking over Fannie Mae and Freddie Mac, along with their $5 trillion of mortgage debt. He did not ask Congress. Congress did not complain. That act ended anything
resembling a free market in housing. Falling equity takes away the credit that Americans need to borrow money to live the good life. They will soon feel betrayed. A widespread sense of betrayal is dangerous for politicians.

A LOSS OF FAITH

We are living in a time in which the fundamental religion of our era has been faith in the redemptive power of the State. Whenever there is a crisis, citizens call upon the State to bail them out. They are convinced that the State has a separate existence which enables it to intervene into the affairs of men, thereby improving the life of almost everyone under its jurisdiction.

This religion of State redemption has been fading in recent years. It gained almost universal acceptance during the Great Depression. The fundamental purpose of the State is no longer seen as justice, but rather to serve as the source of guidance for the free market, without which the economy supposedly cannot sustain long-term economic growth.

There is enormous faith by the public in the ability of bureaucrats to collect data, interpret data, make accurate
predictions, establish incentives that encourage growth, and enforce these incentives without bias. People generally do not believe that God intervenes into the economy with the same frequency and reliability that the State does.

The great redeemer since 1987 has been Alan Greenspan. He had the power of the printing press behind him, and he used it. People concluded that in an economic crisis, under Greenspan's guidance, the Federal Reserve System would be able to overcome all economic setbacks. This faith escalated from 1987 until his retirement in January 2006.

We are now seeing the undermining of this confidence in the ability of the Federal Reserve System to compensate for the downturns in the markets. People are beginning to figure out that Bernanke is in over his head, and the Federal Reserve System seems impotent to overcome the worst economic crisis since the Great Depression.

It is significant that this assessment, namely, that this really is the worst financial crisis since the Great Depression, is now becoming widespread in the media. The assumption that theFederal Reserve, when assisted by the U.S. Treasury, and funded by an extra couple of trillion dollars of Federal debt, will be able to deal with any crisis is now becoming shaky. There are whispers of discontent. Some people are saying that this crisis is more fundamental than what Paulson admitted in the week of September 15.

As we’ve talked about in these pages before, Fed Chairman Ben Bernanke is a devoted student of the Great Depression. You could almost say that a study of the Great Depression - its causes, its quirks, and finding the means to ensure it never happens again - makes up the sum total of Bernanke’s lifework.

In 2002, Bernanke gave a speech titled, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” (You can read the full text here.)

This is where the, uh, taxing part comes in (underscore emphasis mine):

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Do you know what gentle Ben is really saying here? He is saying he can tax the dollars right out of your wallet if he chooses to. And if he has to, he will... and there isn’t a thing you or I can do about it (other than convert those dollars into something else before they get devalued).

Simply put, inflation is a form of hidden tax. Whenever the U.S. government prints dollars from thin air, it lessens the value of the dollars in your bank account.

This is no different than taking money from your bank account... except the process is much more stealthy. When the government practices taxation by inflation, many of us don’t even know we’ve been taxed. The value has been drained from the dollars, even if the dollars are still there.

If you’re still fuzzy on the concept of inflation as a hidden tax, ask yourself this: Why does the government bother with collecting taxes at all? In theory, Uncle Sam could just print up dollars for everything he needs.

If there were, say, $10 trillion in circulation, the government could just print up $10 trillion more for itself.... dropping the value of all existing dollars by 50%, but hey, so what.

If we did it this way, there wouldn’t have to be an IRS. We could abolish April 15th, stop worrying about tax lawyers... When Uncle Sam needs something, he just writes himself a check. So why not do it?

There are at least two reasons why direct “taxation by inflation” - a system where the government prints what it needs - does not happen.

For one, lobbyists and their masters love a complicated tax code. It allows them to exploit loopholes and siphon dough from the system in all kinds of ways.

But, more importantly, taxation via printing press would be too obvious. If we did it that way, most everyone would understand the concept of inflation as a hidden tax. There would be no room left for stealth. A lot more people would pay a lot more attention to those printing presses chugging away in the dead of night.

And that’s really one of the ironies of this whole bailout mess.

Now that the Fed and Treasury have been rebuffed in their efforts to go through the front door, they’re just going to concentrate even harder on saving the system via the back door... and that means big-time taxation without representation (i.e., taxation via the printing press).

No Votes on This One

There won’t be any votes on this. The printing has already begun, as The New York Times spelled out on Monday:

Without the broad bailout plan they invented and lobbied hard for, the two agencies are once again forced to careen from one desperate path to another, and to dig deep into their toolkits to rescue the global financial system. Even before the House stunned the world on Monday by rejecting the Bush administration’s bailout bill, the Fed was already resorting to the oldest action in its book: printing money.

In the past two weeks alone, the Fed has borrowed and lent a whopping $710 billion - more than the cost of the proposed bailout - in an effort to keep the system afloat. Some of that went to an “emergency lending program” for various banks; some of it went to “swap lines” with foreign central banks to help shore up European and Asian money markets; and some of it went to flailing institutions like AIG.

And the ironic thing is, the Fed is just getting started. If a follow-up bailout plan doesn’t pass - and many of those chanting “No! No!” are hoping it won’t - then Bernanke will just gear up the printing presses to an even further degree.

Source: Get Ready for Taxation Without Representation

Separately, in testimony prepared for the Joint Economic Committee, Bernanke said that risks of higher inflation and a serious downturn were both “significant” concerns, thus signaling that the Fed's stance is essentially neutral toward future interest rate moves.

And the president got into the act last night, in an address to the nation in which he detailed, fairly accurately, how we got into this mess, then implored Americans to support the bailout or face truly dire consequences, saying that we can’t let the “irresponsible actions of some undermine the financial security of all.”

Somewhat disingenuously (?), Bush went on to say he regrets the “commitment of taxpayers’ hard-earned money” to this. Of course, there’s no taxpayer money left this year, so the cost will be covered by the printing press, thereby devaluing whatever money taxpayers have left in their wallets.

The day’s hard number was a bad one. The National Association of Realtors reported that resales of single family homes and condos cratered by 2.2% in August. Economists instead had been expecting a slight rise.

But the inventory of unsold homes on the market fell 7% -- the biggest drop since December 2006, perhaps because the median sales price fell 9.5%, year over year.

Also hurting the euro was the closely-watched Ifo Institute's German business climate index, which fell to 92.9 in September from a reading of 94.8 in August, far worse than economists’ expectations for a decline to only 94.0.

Source: Ben and Hank, Hank and Ben - Congress listens, fails to move. Bush begs a skeptical America to get on board.