Global Economics and Management

Excerpt from Henry Paulson's new book - WSJ.com

Here is Hank Paulson's view of the events we read about for the last class session. As one of my thesis advisors used to say, "not uniformly rewarding".

More explosive revelations are apparently found elsewhere in Paulson's book. For an example, let me quote David Warsh over at Economic Principals: 

"Threats pile up. In On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, his just-published memoir, former Treasury Secretary Henry Paulson reports that high-ranking Russian officials approached their Chinese counterparts in August 2008 to propose dumping Fannie Mae and Freddie Mac bonds in order to precipitate a crisis in financial markets and force a US government bailout.

The Russians were about to go to war in Georgia, and a demonstration of fragility in New York would have been a welcome diversion. The Chinese government declined, and told Paulson about the proffer while he was in Beijing for the Olympics. The crisis arrived in New York in September anyway, with the bankruptcy of Lehman Brothers."

Summary of economic news from last week

Calculated Risk has a great digest of crisis-related economic news from last week. The sad bottom line: this crisis is far from over. Take a look.

Banking Crises and Sovereign Debt Crises

Via Mankiw, a superb article by Reinhart and Rogoff on how banking crises are usually followed by large increases in public debt, and thus sovereign debt crises. The increase in public debt in itself is usually associated with declining economic growth. The authors discuss the implications of these historical regularities for the current crisis, and conclude that this time is no different... A highly recommended read, very much in line with the recent discussions we have had in class.

Econbrowser: Strong GDP growth with weak fundamentals

This easy-to-understand blog post by Jim Hamilton over at Econbrowser clarifies why the 5.7% GDP growth figure recently announced for the 4th quarter of 2009 is not as rosy as it seems. Commentators have already pointed out that much of this number is due to changes in inventories, but the virtue of Hamilton's post is to explain exactly how inventory growth factors into GDP growth. Highly recommended reading.

A bailout of Greece?

Things are not looking good on the sovereign debt front when you read articles like this one...

Negative interest rates

During last Thursday's class session David Lewry pointed out that short term rates on Treasury bills had turned negative briefly in the aftermath of the crisis. He subsequently sent me this article, detailing a similar event from March 2009. Well, it happened again today. Negative rates means that purchasers of these bills need to pay the US Treasury for the privilege of holding them. This can only happen in a context of high volatility when there is a flight to the safety provided by US government assets.

Why is this happening now? One explanation is that global capital is seeking safety in the context of heightened sovereign risk. Recent problems in Dubai, Greece and Japan suggest that if another financial crisis were to occur in 2010, sovereign debt would likely be at the center of the action...

Strategic defaults

When a homeowner owes more on their property than the property is worth, there is an incentive for a strategic default. That is because, in the United States, most mortgage loans are non-recourse - the only collateral put up against the loan is the house itself, so the bank cannot go after your other assets if you fail to pay your mortgage or walk away from your home. Households in good financial situation may thus walk away from a property not because they are compelled to file for bankruptcy, but because it is a good financial move from their perspective. Hence the word "strategic".

Calculated Risk blog points to a good example of strategic default in the commercial real estate market. Tishman Speyer and Blackrock are walking away from two New York properties on which they owe more than the properties are worth.

Moral constraints kept strategic defaults contained for a while. But the more they occur, the more socially acceptable it becomes to strategically default. This is the finding of a new paper coauthored by Paola Sapienza of Northwestern's Kellogg School of Management, which Paola presented last fall at our GEM Faculty Seminar.

In a context where roughly 1 out of 4 homeowners owes more on their house than their house is worth, a wave of strategic defaults could make the foreclosure crisis we have witnessed so far look like small change.

A contest

The first commenter to guess who (in 2002, after 9/11 and the internet bubble burst) wrote the following paragraph, gets a free UCLAAnderson coffee mug:

"To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

Googling, Yahooing, and other internet searching not allowed. Honor system.

Subprime Fallout Hits Home in South Carolina - WSJ.com

This WSJ article puts a human face on the topic we will discuss tomorrow: how a financial crisis diffuses to the real economy, creating a recession. The article provides a direct mechanism, by looking at the fate of former employees of subprime mortgage issuing institutions.

FHA Aims to Tighten Credit Without Hurting Economy - WSJ.com

This article from the Wall Street Journal illustrates perfectly the major dilemma facing financial institutions and policymakers at the moment: Keep lending criteria lax, and you play the same game that led to the current crisis. Tighten lending criteria too much, and you run the risk of prolonging the downturn, or of bringing about a double-dip recession. 

The article illustrates this dilemma for the case of FHA-backed loans. As you will recall from class, FHA backed loans are mortgage loans insured by the Federal Housing Administration (FHA), to promote affordable homeownership for lower income households. With the collapse of the subprime market FHA-backed loans have become a larger chunk of the market, and if the FHA drops some lenders from its insurance scheme, first-time, low-income homebuyers might face a drying up of credit. If it does not, the FHA risks finding itself in dire financial straits, requiring, you guessed it, a bailout. 

What to do?