207) The impact of slowdown on India

After asserting that the global financial meltdown will not affect us, it is now being acknowledged that India is impacted and the effects will intensify. A flurry of activity to size up the happenings and counter the financial virus fast spreading across the globe is now being witnessed. 

As early as April 2008, the early alarms had been sounded but our preoccupation with inflation-management made us virtually sidestep it, all in the belief that we were not vulnerable. This was somewhat naïve looking at the magnitude of the predicament. 

The subprime crisis was translating into huge losses, and resulting in billions of dollars of capital raisings, including public offerings and asset-disposals. Market caps were plunging sharply, and not just in the US, but also of European banks. Central banks across the globe had begun to revive financial institutions, hit by what former Federal Reserve governor Alan Greenspan has described as ‘the crisis of the century’.

India may be one of the least open economies in Asia but its external trade already constitutes over 40% of its GDP. Net investments by FIIs in Indian stock exchanges by January 2008 were $65 billion. In the last four years India has received $50 billion as FDI. 

On October 23, by which time FIIs had pulled out over $10 billion, the rupee plunged to 49.79 against the dollar, in comparison to under Rs 39 a year ago. GDP growth had started slowing and it had become obvious that the projected growth at 9% was untenable. 

By mid-October, India was well in the midst of a global slowdown. Estimates of annual GDP growth had been lowered from 9% to 7.5%. During Q1 2008-09 growth was 7.9% compared to 9.2% in Q1 2007-08. Deceleration has been widespread. Industrial growth is much slower. 

April-August 2008 saw 4.9% growth compared to 8.5% in April-August 2007 and 10% during entire 2007-08. Expansion in manufacturing, the emerging star of Indian economy, fell from 10.6% to 5.2%. Electricity generation nose-dived from 8.3% to 2.3%.

Agriculture declined in Q1 2008-09 from 4.4% to 3% and services from 10.6% to 10.2%. Foreign trade during H1 2008-09 registered a deficit of $60 billion as against $30 billion in H1 2007-08. Hitherto, export growth was being bolstered by rising commodity prices and the yet strong demand from emerging markets and oil producers. All such contributory factors are no longer there. 

There has been a reversal of portfolio equity flows, largely because of foreign institutions’ need to enhance their liquidity positions and the overall reduction in the risk appetite of global investors. Equity market is down 30% since April 2008 and had dipped below the 10,000 level. A sharp decline in FII inflows exacerbated the downward pressure with the rupee depreciating by almost 25% and touching a five-year low of 50.18 on November20. 

Since mid-September, the tight liquidity conditions in the economy have led to extreme volatility in the money market. Inter bank call rates have been posting significant jumps, well above the official repo and reverse-repo corridor. 

By October 20, the call rates had become 20% and averaged 12% between mid-September and mid-October. By mid-October the economy had clearly deviated from its long run growth path. The positive cycle had turned negative and the actual growth had lagged behind the potential output growth. The manufacturing inflation gap has become positive, with the actual inflation being higher than warranted for many months. 

Our response to the emerging global turmoil has been essentially monetary. The RBI, which for 18 months had been increasing interest rates and the cash reserve ratio to cool down the overheating economy, has since October changed tracks. Repo rate has been cut by 150 bps, CRR by 350 points and SLR reduced from 25% to 24%. 

Such facilities aim at infusing greater liquidity and making credit cheaper. However, the additional liquidity of Rs 2 lakh crore has primarily gone to offset the sizeablemoney withdrawals which occurred upon issue of bonds to oil and fertiliser companies for not effecting price increases. Commercial banks have so far not significantly reduced their lending rates or started lending as before. 

Till the fragile financial systems start functioning normally again, the various macro measures might not be fully effective particularly in the transmission of increased liquidity to investors and consumers. Many non-linear effects are anticipated as weaknesses in our trading partners spill over to us. There would also be reduction in investment financed through FDI, remittances, international debt and aid. 

India, like many other Asian countries, is expected to suffer severely from the lagged effects of the commodities’ price shock. Also China, with whom Indian foreign trade has been steadily growing, is highly exposed to the downturn in the US and Europe. Already Indian iron ore mine owners have cut down their output by 40%. 

The number of investor accounts at stock exchanges has surged. A crash in equity prices is affecting more people than ever before. Property markets have deepened substantially and the losing values of real estate have a potential multiplier effect. 

The global credit crunch has caused more restrictive lending by commercial banks, upon which Indian corporates and households heavily depend for finance. The monetary measures recently initiated are not adequate to spur banks to lend more as they are concerned, and perhaps rightly, about short-term prospects of the economy. 

Most Indian IT firms are vulnerable to the emerging global recession, 70% of India’s $40 billion software exports are to the US and 40% of it for financial services which are shrinking rapidly. Our manufacturing and construction trade face prospects of further slackening investment. 

Financial services are up against tight liquidity and falling markets. Plummeting travel and tourism are slowing down transportation and hospitality sectors. More focused action, including fiscal, is needed to stem the worsening of the real economy. 

Ajay Dua

(The author is a former secretary to the government of India)

206) G20 or 420 ?

The "Group of 20" nations met in Washington over the weekend. The weather was cloudy and cool. The winds were blowing west-by-north-west at 14 miles per hour. But what came out was mostly hot air. Stale, hot air.

President Bush who is destined - unless saved by some miracle - to go on record as the worst President in the history of modern day USA laid the foundation for this nothingness. 

Before the meeting began President Bush reminded us all that this financial crisis was not a failure of capitalism - there was no need to discourage financial innovation with excessive regulation. 

Sure, the world needs a lot more financial innovation to be wrapped around the greed and slimy business practices of the financial geniuses.

The Europeans wanted more global oversight, more regulation. Eventually, the G-20 came out with a list of 20 points: a promise to do more and put in action with a notice that "we will meet again by April 30, 2009, to review the implementation of the principles and decisions agreed today".

Doctor, what’s the problem? 

But before any doctor sets forth a prescription, there must be a clear understanding of the disease. A treatment can only be effective when one understands the illness and identifies the cure.

So, what are the events that led us to where we are? What are the crises that led to a dinner and weekend meeting of the leaders of 20 countries that represent about 90% of the global GDP and 75% of the world’s population?

This is what the statement of the G-20 had to say (points 3 and 4):

"Root Causes of the Current Crisis

3. During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence.

At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.

Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

4. Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption."

Now let’s put that in English.

G-20: During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence

The English version: After the technology bust in 2000 and the 9/11 terrorist attacks on the US, the global economies were on the edge of a long recession and - to prevent that from happening - the central bankers of the world kept on cutting interest rates with a view to encouraging economic activity. Whenever there is pain around the corner, the doctor prescribes the pain killer to remove the pain. The central bankers prescribed the drug ecstasy to turn that pain into the most orgasmic experience. The central bankers printed so much money that the financial geniuses figured out what to do with it: they gave it to people who could not really afford to ever repay it. And each time they lent money, the financial geniuses made a profit. And each time they made a profit, the financial firms rewarded themselves with salaries and USD 65 million bonuses.

G-20: At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.

The English version: Hey, if you were cleaning out USD 1 million in salary every year (and there must have been 100,000 people in the field of finance, law, accounting, and consultancy who made that much money) and then getting a bonus and stock options over and above that - would you care about the vulnerability in the "system". Man, you were the "system"! People relied on you for ethical practices and you didn’t give a damn about that - your annual salary and the sound of the bonus money getting to your bank account sounded sweeter than God’s church bells.

G-20: Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

The English version: Mr. Alan Greenspan was the head of the US Federal Reserve. He knew what he was doing: giving money away for free to encourage businesses to take risks - and spur economic activity. The European central bankers were appalled at the "cheap money" policy of the US. They knew what Mr. Greenspan was doing - building a bubble economy. An economy fuelled by higher debt at the consumer level. An economy oiled by financial products that needed more global supervision. Mr. Brown, the then equivalent of the Finance Minister of the UK (and now the Prime Minister) did not want more regulation and oversight in Europe. His reason: because the US was grappling with the post-Enron and post-WorldCom frauds by putting in place more reporting standards for corporate governance, financial businesses were moving more of their innovation to London and Europe. If Europe placed more regulation, then it would lose its "competitive" advantage. London could no longe r challenge New York as a financial centre. Mr. Brown’s arguments prevailed. Back in the US, the current "Finance Minister" Hank Paulson - who was then head of Goldman, Sachs pleaded with the SEC to allow Wall Street firms to borrow more. And the SEC approved that: more of Mr. Greenspan’s free money found its way into hands of the financial geniuses. The bonuses got higher and higher.

G-20: 4. Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption

The English version: Maybe the Chinese have not picked this one - but they are being blamed for the "current situation". Follow me on this line of thought. The US central bank wants to give money free in the hope that businesses borrow this money and businesses invest. This investment creates jobs. Job creation leads to higher income. Higher income leads to more consumption. Higher consumption leads to higher economic activity. This leads to businesses investing more. More jobs, more incomes, more consumption...a virtuous cycle is established. But that is in the text books.

This is what happened in real life: The US central bank gave free money. The Wall Street firms lent this money to individuals in USA to consume more. The individuals consumed goods that were "Made in China". Investments did increase: in factories in China. Salaries did increase: of the labour class in China. Businesses did flourish: that is how the Wall Street firms could afford to paid out the big bonuses. The "structural" imbalance was caused by the fact that the Chinese - and other exporting countries that benefited from the surge in US household consumption - did not allow their own currencies to strengthen. If the Chinese currency had strengthened, exports from China would have been more expensive - and China would have lost out to other exporting nations like Vietnam, Indonesia, Thailand, Malaysia, and Mexico. Exports to USA allowed China to create jobs and increase employment and brought stability within China. All this because China kept its currency low and allowed exports to flourish.

At the US end, the packaging and re-packaging of financial loans - as one commentator noted - was the only export. The US exported USD 300 billion worth of these loans mostly to the European banks (remember London wanted to be the centre of the financial universe) and some to the Japanese and Asian banks.

The "problem" was not that Wall Street was giving loans to US consumers. That is the job of any finance company: to arrange finance.

The "problem" was that Wall Street and the credit rating companies like S&P and Moody’s were rewarded to help sustain a lie: the lie that the loans being given to people who could not really afford them were able to pay these loans back.

Along the way, everyone got their pound of flesh: the Wall Street firms got the salaries and bonuses; the rating agencies got their fees; and the Chinese and the exporters got their jobs and built foreign exchange reserves.

And, yes, the US consumer - financially illiterate and unaware of www.personalfn.com - was able to buy new homes, new cars, new everything. All for some debt obligation and interest payments that seemed really cheap - and (due to financial innovation) began sometime in the distant future.

So, if this is indeed the problem - in simple English - what is the cure?

Complexities of drugs
The last time there was a problem - and, sigh, it involved the same Wall Street firms - the US Fed prescribed "cheap money" as the cure. 
But drugs have side-effects. Any doctor knows that. 
And in certain combinations - they can be lethal. 
Mr Greenspan knows that by now - you mix free money, with the ability of Wall Street firms to borrow infinitely, and sprinkle that with self-regulation - you end up where the world is today.

So the action plan that the G-20 has recommended is one of more oversight, more regulation. And more transparency of the accounting standards used to evaluate the risks of the financial instruments created by the financial geniuses.

Good stuff, I am sure and the G-20 will figure what the new system will look like.

But they have not addressed two issues:
1) The G-20 statement was silent on whether they will punish the crooks who mis-sold financial products to borrowers and to the lenders, and
2) The G-20 statement did not spell out how "unsustainable global macroeconomic outcomes" will be addressed. Will China - and other exporters - allow their currencies to strengthen so that they stop exporting - and will China risk a social upheaval at home due to job losses from shutting down export factories? China had already announced a USD 560 billion stimulus package - to offset the decline in exports to countries like the US.

So the G-20 was what it was: a lot of good photo ops for the leaders and some long-worded statements.

But, "hot air" is sometimes a good thing. 
It tells the doctor that the patient is still alive. 
Still pretty sick - but alive.

The world will take some time to get back on its feet and run again.

And India? I hope that the policy makers get their act together and start chalking out some serious investments in infrastructure (and not just the electronic voting machines) to build the base that India needs to take it to an 8% rate of annual growth in the economy - on a sustainable basis. 
And the Indian stock markets? Let me know when SEBI shuts down P-Notes then we can have a rational discussion. 
Until then, it remains a casino.

A wonderful, no-failure-in-settlement-systems, highly efficient casino. 

But a casino - not a vehicle to allow Indian companies to attract long-term capital to build out India’s economy.

205) Depression economics

Throw caution to the wind and money at the problem

The economic news, in case you haven't noticed, keeps getting worse. Bad as it is, I don't expect another Great Depression. In fact, we probably won't see the unemployment rate match its post-Depression peak of 10.7 percent, reached in 1982 (although I wish I was sure about that).

We are already, however, well into the realm of what I call depression economics. By that I mean a state of affairs like that of the 1930s in which the usual tools of economic policy -- above all, the Federal Reserve's ability to pump up the economy by cutting interest rates -- have lost all traction. When depression economics prevails, the usual rules of economic policy no longer apply: virtue becomes vice, caution is risky and prudence is folly.

To see what I'm talking about, consider the implications of the latest piece of terrible economic news: Thursday's report on new claims for unemployment insurance, which have now passed the half-million mark. Bad as this report was, viewed in isolation it might not seem catastrophic. After all, it was in the same ballpark as numbers reached during the 2001 recession and the 1990-91 recession, both of which ended up being relatively mild by historical standards (although in each case it took a long time before the job market recovered).

But on both of these earlier occasions the standard policy response to a weak economy -- a cut in the federal funds rate, the interest rate most directly affected by Fed policy -- was still available. Today, it isn't: The effective federal funds rate (as opposed to the official target, which for technical reasons has become meaningless) has averaged less than 0.3 percent in recent days. Basically, there's nothing left to cut.

And with no possibility of further interest rate cuts, there's nothing to stop the economy's downward momentum. Rising unemployment will lead to further cuts in consumer spending, which Best Buy warned this week has already suffered a "seismic" decline. Weak consumer spending will lead to cutbacks in business investment plans. And the weakening economy will lead to more job cuts, provoking a further cycle of contraction.

To pull us out of this downward spiral, the federal government will have to provide economic stimulus in the form of higher spending and greater aid to those in distress -- and the stimulus plan won't come soon enough or be strong enough unless politicians and economic officials are able to transcend several conventional prejudices.

One of these prejudices is the fear of red ink. In normal times, it's good to worry about the budget deficit -- and fiscal responsibility is a virtue we'll need to relearn as soon as this crisis is past. When depression economics prevails, however, this virtue becomes a vice. FDR's premature attempt to balance the budget in 1937 almost destroyed the New Deal.

Another prejudice is the belief that policy should move cautiously. In normal times, this makes sense: You shouldn't make big changes in policy until it's clear they're needed. Under current conditions, however, caution is risky, because big changes for the worse are already happening, and any delay in acting raises the chance of a deeper economic disaster. The policy response should be as well-crafted as possible, but time is of the essence.

Finally, in normal times, modesty and prudence in policy goals are good things. Under current conditions, however, it's much better to err on the side of doing too much than on the side of doing too little. The risk, if the stimulus plan turns out to be more than needed, is that the economy might overheat, leading to inflation -- but the Federal Reserve can always head off that threat by raising interest rates. On the other hand, if the stimulus plan is too small there's nothing the Fed can do to make up for the shortfall. So when depression economics prevails, prudence is folly.

What does all this say about economic policy in the near future? The Obama administration will almost certainly take office in the face of an economy looking even worse than it does now. Indeed, Goldman Sachs predicts that the unemployment rate, currently at 6.5 percent, will reach 8.5 percent by the end of next year.

All indications are that the new administration will offer a major stimulus package. My own back-of-the-envelope calculations say that the package should be huge, on the order of $600 billion.

So the question becomes, will the Obama people dare to propose something on that scale?

Let's hope that the answer to that question is yes, that the new administration will indeed be that daring. For we're now in a situation where it would be very dangerous to give in to conventional notions of prudence.

Paul Krugman is a Nobel Prize-winning professor of economics at Princeton University.

204) Brave new world of derivatives

Greenspan never saw how derivatives would make the housing crisis a global one.

Some say that derivatives rank right up there with antibiotics and the microprocessor chip as one of the great innovations of the modern era.

Derivatives are financial instruments that are used to reduce financial risk, just as a fire insurance policy is used to reduce the risk of a fire by compensating possible damage in the event of one. Why did, then, Warren Buffett, whose financial acumen is legendary, describe them recently as “weapons of mass destruction”? Where did they come from and how did they become such objects of veneration as well as hate?

In downtown Chicago stands the 45-storey building that houses the Chicago Board of Trade, the institution that gave birth to the derivatives business. Beautiful as its art deco architecture is, there is nothing much to set it apart from the many other tall buildings that surround it. Except for one thing. Right at its very top there is a two-storey tall statue of a Greek goddess. This is Ceres, the Greek goddess of grain from who the word “cereal” comes.

This is where it all started. A group of merchants trading in the food grains grown in the surrounding Midwest came up with the ingenious and useful idea of offering farmers a firm “future” price for their crop many months before it came to the market reducing the risks that farmers took during their long season of labour. Grain “futures” prospered for decades till the US government, in the 1960s, started offering a minimum price for the crop. This considerably slowed down the grain futures trade. The Chicago grain future traders sat around their trading pits for a while, smoking cigars and reading newspapers with nothing much to do till one of them thought of the idea of starting trading in another kind of futures: using the Dow Jones Industrial Average of equity shares in the New York Stock Exchange as the “underlier” instead of grain.

But, before starting off this new line of business, they had to solve a problem: how to put a price on this new form of “future”. An out-of-the-box thinker among them, Mathew Gladstein, asked for help from a group of local Chicago economists, Merton, Black and Scholes. The mathematical model they came up with, the Black-Scholes model, did its job of pricing options so well that Gladstein made tons of money using it, Merton and Scholes won the Nobel Prize in Economics for it, and started the rush of mathematicians to the stock market.

Soon, other enterprising people thought up other “derived” financial instruments based on many other “underliers”: bonds issued by companies and municipalities, mortgages that people took out on their homes.

It is not hard to see why such “derived” securities or “derivatives” have become so popular. A bank that makes a loan, for example, for a house, faces many different types of risk. The borrower, for instance, may not be able to return the loan on due date. Or, he may not be able to keep up with interest payments. Or, the market interest rate may rise far above the rate the bank has given the loan, leaving the bank stuck with a loan at a low interest rate. Or an earthquake might hit the area demolishing the borrower’s business. Or, high inflation may reduce the value of the loan by the time it gets repaid. Derivatives are a way to “hedge” against these risks. For example, a housing loan to a borrower in, say, Cochin can be combined with a housing loan in Mumbai and another one in Bangalore under one common instrument and this combined “derivative” can be sold to an investor. This combination reduces the risk of disparate housing markets such as Cochin, Mumbai and Bangalore all suffering downturns at the same time. The investor in this derivative rightly believes that the instrument he holds has a balanced risk.

If derivatives can diversify risk, as just described, what can go wrong? For one, the borrowers may have mis-represented their income. Or, the loan issuer may not have verified their incomes. Or, they may have borrowed 95 per cent of the value of their houses such that if property prices decline by, say, 20 per cent, the asset cover may become inadequate. In all of these cases, should interest rates rise sharply, from say, 6 per cent to 10 per cent, these borrowers may no longer be able to meet their monthly payments. When Greenspan, who was Chairman of the US Federal Reserve Board, was told about similar issues developing in the US mortgage securities market he believed that such problems in the housing sector would be restricted to a city and could never become a national, let alone an international problem.

This would normally have been true, but mortgaged-backed securities were sold not only nationally in the United States but also throughout Europe and Asia. When the US housing bubble burst and borrowers started defaulting on their mortgage payments, the value of the mortgage securities fell precipitously.The shock waves were transmitted throughout the world. What started as a crisis in some specific parts of the US now became a worldwide financial crisis.

In the next and final part, we’ll examine why so many smart people in storied investment banks like Morgan Stanley, Lehman Brothers and Bear Stearns, in powerhouses such as Citigroup and Royal Bank of Scotland found these derivatives so attractive that they just couldn’t resist them.

Ajit Balakrishnan 

203) Depressing times: Irvin Fisher's Debt-Deflation theory

It seems Irvin Fisher's Debt-Deflation Theory, developed in 1933 during great depression, is repeating itself

during the present crisis, as indicated by present slump in oil & commodity prices.

IN JUST a few brutal months, the prospects for the world economy have deteriorated with remarkable speed. Rich countries had seemed set for a shallow, muddle-through recession; now a much deeper slump is on the cards. In a sign of growing concern about American consumers, the Treasury and Federal Reserve on November 12th focused their rescue efforts on loans for cars and college and on credit cards. Central banks, recently so fearful of inflation, are now slashing interest rates to stop it falling too far. It will not be easy: deflation—annual falls in consumer prices—is increasingly likely next year. But recalling the 1930s, policymakers will be anxious to ensure that it does not take hold and turn crisis into catastrophe.

To consider the possibility of falling prices may seem odd when inflation is still uncomfortably high. In America, it reached 5.6% in July, the highest rate since 1991. In the same month inflation in the euro area surged to 4%. Britain’s consumer-price inflation hit 5.2% in September, well above the government’s target of 2%. This high inflation was mostly the result of the surge in commodity prices in the first half of the year. “Core” inflation, excluding food and energy costs, was far more stable.

But since the summer the commodity boom has turned to bust, changing the inflation outlook dramatically. The price of a barrel of crude oil has tumbled from a peak of $147 in July to below $60 in recent days. The Economist’s index of non-oil commodity prices has fallen by 40% since July. If raw-material prices remain at these lower levels, the year-on-year change in the retail prices of food and fuel will turn sharply negative in 2009.

That will add to other downward pressure on inflation. As economies fall deeper into recession and spending shrinks, firms will have to compete harder for sales by pricing their wares keenly. A glut of supply is evident in America’s jobs market: the unemployment rate rose to 6.5% in October. A year earlier it was just 4.8%.

Falling food prices have quickly had an effect on inflation in China, which fell to 4% in October from a peak of 8.7% in February. In the rich world, a period of deflation seems more likely in America than in Europe. Crude-oil costs are a bigger slice of the prices American consumers pay for petrol: lower sales taxes and fuel duties mean swings in oil markets have a bigger effect on pump prices. Motor fuel also accounts for a larger share of Americans’ spending, so falling prices will depress inflation by more. Prices tend to be less “sticky”: they respond more readily to economic conditions because markets are more flexible than in Europe. A stronger dollar will add to deflationary pressures in America while easing them elsewhere.

The year-on-year fall in oil prices is likely to be steepest in the third quarter next year, when the base will be this summer’s peak. Economists at Goldman Sachs reckon that America’s inflation rate will briefly turn negative at that point. Inflation in the euro area seems set to reach a low then too, even if prices do not actually fall. Speaking after the European Central Bank’s (ECB) half-point cut in interest rates on November 6th, Jean-Claude Trichet, the bank’s chief, allowed that inflation could fall well below the ECB’s target ceiling of 2% next year. But such a drop would be “short-lived and therefore not relevant” to interest-rate decisions. The Bank of England sees deflation as more than just a remote risk. Its Inflation Report, published on November 12th, puts the spread of likely inflation rates at between -1% and 3% in two years’ time. It is the first time the bank’s fan chart, which projects where inflation is likely to lie nine times out of ten, has encompassed deflation.

A commodity-led fall in inflation ought to be good news for rich economies. It boosts consumers’ real incomes and fattens firms’ profit margins. Yet there is something pernicious about inflation falling too far, too fast. Because falling prices make debt more expensive, indebted households would be more anxious to pay off loans, even as other consumers were benefiting from a boost to their purchasing power. If deflation took hold, the gap in demand left by those fleeing debt would not be filled by cash-rich consumers, who tend to be less free-spending.

A deadly mix of falling prices and high leverage could foment a “debt-deflation” of the type first described by Irving Fisher, an American economist, in 1933. In this schema, debt-laden firms and consumers rush to repay loans as credit dries up. That hurts demand and leads to price cuts. The deflation in turn increases the real cost of debt. It also means that real interest rates can’t be negative, and so are undesirably high. That spurs yet more repayment so that, in Fisher’s words, the “liquidation defeats itself.”

Fisher’s theory is of more than just academic interest. Recent lending surveys by the Federal Reserve and the ECB showed a larger share of banks tightened their lending criteria in October than in July. Such is the concern in America that on November 12th regulators said they would scrutinise the dividend policies of banks that did not increase lending.

The surveys also revealed a reluctance to borrow, which tallies with signs of a collapse in spending. Foreign orders for German capital goods slumped by 14% in September, suggesting firms worldwide are cutting investment. Car sales in America and Europe are plummeting. American retailers, such as Neiman Marcus, J.C. Penney and Gap, reported double-digit falls in sales in the year to October. The retail data in Britain are grim too, which is a big worry for firms which have been through the private-equity mill and are loaded with debt. If sales do not respond soon to interest-rate cuts, some retailers may resort to deep discounts as Christmas approaches.

Bond markets expect consumer prices in America to fall by as much as 2½% over the next year, according to Mark Capleton, of the Royal Bank of Scotland. Inflation in the euro area is expected to be close to zero. When prices were climbing rapidly, central banks fretted that consumers’ inflation expectations would rise in response. They will now be as keen to keep them from falling too far. That means interest rates in rich countries may soon fall to zero; some are already close.

Deflation is not the only fear, however. Investors seem keen to hedge against all outcomes. “The options market tells us that inflation uncertainty has rocketed,” says Mr Capleton. That reflects fears that policymakers, in their efforts to tackle deflation, will go too far the other way.

The Economist

202) The global economic summit - After the fall

On November 15th world leaders are due to sit around a table in Washington, DC, to fix finance. They have their work cut out.

THE leaders arriving in Washington, DC, for this weekend’s economic summit are being presumptuous. If they want what they are calling Bretton Woods 2 to live up to the original, which took place in New Hampshire overshadowed by war and the Depression, it will have to establish a new economic order for the capitalist world. In 1944 that meant creating the IMF, the World Bank and a body to oversee world trade. Imagine Hank Paulson, America’s treasury secretary, as John Maynard Keynes; or picture Gordon Brown, Britain’s prime minister, as Winston Churchill (as Mr Brown himself secretly may), and you get a sense of the task ahead.

The Bretton Woodsmen of 2008 are grabbing the credit before they have earned it—rather as all those subprime householders did. More than two years of gruelling technical work laid the ground for the wartime conference of officials and finance ministers (prime ministers and presidents had other things to deal with). By contrast, the leaders gathering this weekend from the G20, a mix of industrial and emerging countries, plus the European Union, have cobbled together an agenda in a few frenetic weeks. They will doubtless produce no shortage of promises. Just what these are worth will depend on sweat and summits yet to come.

The summit is sure to stir up a debate about the institutions that oversee the international economy. By convening the G20 rather than the closed, rich club of the G7, the old order has in effect acknowledged that the rest of the world has become too important to bar from the room. But what new order should take its place? Answering that question has been a parlour game for economists since long before the crisis. By encouraging them to dust off their pet ideas, the summit will at the very least create a bull market in new schemes for global economic governance.

Because everyone agrees that something big needs fixing and that the world expects action, calling the summit Bretton Woods 2 could yet come to be seen as a rallying cry for reform. And yet there are lots of reasons to see it as vainglory. The agenda is vague and sprawling. With so many of the world's political leaders sitting around the table, it will be hard to escape platitudes and hypocrisy. There may be disagreements—especially where sovereignty or competitiveness is threatened. And most of all, the recent international financial collaboration is fraught with in-fighting and complexity.

At first sight, this summit seems no different. For instance, consider how Mr Brown and Nicolas Sarkozy, the president of France, have vied to claim paternity of the summit for their own domestic reasons. Mr Sarkozy sees a chance to show he is a man of action, and he will find it easier to force through domestic reform if he can show he is not in thrall to all that Anglo-Saxon free-market ideology.

Mr Brown has been calling for a global summit for weeks, emboldened by international acclaim for his plan to rescue Britain’s banking system. The prime minister is keen to show that the crisis is one of those worldwide messes that—honestly—has nothing to do with the past 11 years of Labour government. And he wants to play the lead in Washington so as to protect the free-market City of London from the Gallic machinations of Mr Sarkozy.

From despair, hope

But there is more to the summit than politics. Perhaps inevitably, the run-up to the summit has produced dozens of different proposals. Broadly, they fall into three areas. First and most urgent is the need to limit the crisis, which is even now spiralling from the rich world to emerging economies. Second is financial regulation: its flaws have been laid bare, and the summiteers will want to put it right. Third is global macroeconomics. The G20 needs to find ways to correct the imbalances—Asian saving and Western spending—that lay behind the boom.

Pervasive economic gloom is the best reason for hoping that something important will come of this weekend’s meeting. After savaging the financial markets, the credit crisis has broken loose into the real economy. This month the IMF lowered its forecast for global growth next year by 0.8 percentage points, to 2.2%. The rich world is already in recession. Unemployment, foreclosures and corporate bankruptcies are rising. Emerging economies have also been ensnared, as investors from richer countries retreat to their home markets. The fund cut its forecast for their growth rate by a percentage point, to 5.1%.

Such pain demands an ambitious policy response. On November 6th Kevin Warsh, a governor of the Federal Reserve, put it in dramatic terms: “We are witnessing a fundamental reassessment of the value of every asset everywhere in the world,” he said. “The establishment of a new financial architecture, thus, is the essential policy response to the greatest economic challenge of our time.”

The easy bit will be to harness that sense of urgency to produce concerted interest-rate cuts and government spending. Already, several countries are talking about a co-ordinated fiscal stimulus to help offset a collapse of private-sector demand. China set the standard on November 9th, with a huge spending plan worth 4 trillion yuan (nearly $600 billion), or about 15% of GDP (see article). Not everyone can muster such resources, but other countries, including America and Britain, are preparing to act too. Germany, which has promised a piffling €12 billion ($15 billion), may be shamed into spending more. With concerted action, countries will find that each national stimulus buys more confidence than it would do alone.

Many commentators also want to build confidence by increasing the spending power of the IMF. If a large emerging market, such as Poland or Turkey, were to need help, says Willem Buiter, an economist at the London School of Economics, its present resources of $250 billion “would be gone before you can say ‘special drawing rights’.” Although some European delegates want to strengthen the IMF, the Americans are resisting: the summit may produce nothing more than a pledge to find the money if the fund needs it.

In financial regulation, some changes ought to be easy to agree on—such as ensuring that banks stop holding assets off their balance-sheets and put capital aside against possible failures in a wider range of securities. The summit is also likely to try to bring order to the market for credit-default swaps, which trade the risk that borrowers will not honour bonds, by concluding that, within 120 days, the business should be routed through clearing houses rather than settled privately by investors.

That is progress, to be sure. But it is small potatoes next to the summiteers’ ambitions. And little else will be easy, even if the leaders can issue a declaration that sets out their common principles and a schedule of negotiations for further reform. To see why, leave behind the first Bretton Woods conference for the more recent history of international financial regulation.

The difficulty with cross-border rules in finance is explained by Barry Eichengreen, a professor at the University of California, Berkeley, and one of 20 economists from around the world who have written an “e-book”* that describes what this weekend’s summit should do.

On the one hand, finance is every country’s business. This crisis has shown that what happens deep inside one national financial system can wreck another halfway across the world. In the United States subprime lending was a relatively small bit of the mortgage market—itself just a part of America’s financial markets. And yet the cascade of failing credit and risk aversion that began there, partly as a result of inadequate supervision, has spread not just to the overstretched banking systems of Europe, but also now to untroubled banks in emerging markets.

On the other hand, nation-states jealously guard the right to oversee their own banks. This is not just out of principle, or a desire to see that the regulations suit their own financial institutions—although most regulators would think these alone to be sufficient reason. It is also because, when a crisis comes, the nation-state foots the bill for a bail-out. In addition, Wendy Dobson, of the University of Toronto, notes that regulators need intimate local knowledge of their charges and their own financial structures if they are to have a hope of prevailing—and even then, as the world has seen, the odds are against them.

The tug between national and supranational regulation has gradually led to an ad hoc arrangement for the international banking system. In the 1980s America and Britain grew worried about the expansion of Japanese banks, which by 1988 accounted for nine of the world’s ten largest by assets, up from one at the start of the decade. What bothered the West was that Japanese regulators allowed their banks to count shareholdings as core capital. Cheap capital fed their growth. And it was indeed reckless, as the subsequent collapse of the Japanese stockmarket showed.

Under the auspices of the Bank for International Settlements (BIS), a central bankers’ central bank in Basel, in Switzerland, the big economies agreed to set common standards for what counted as capital and how much a bank should hold in order to qualify as safe. Their negotiations were partly about rules to make the global financial system more resilient. But they were also, in effect, about a trade dispute, over what the West saw as a subsidy to Japan’s banks. This ambiguity between the common good and national interests complicates all financial negotiations—including any that will follow the G20 summit.

Andrew Gracie, who worked on regulatory design at the Bank of England and founded Crisis Management Analytics, which advises central banks on financial stability, points out that right from the start regulators looked at systemic risk one bank at a time. The assumption was that if each institution was safe, then the system as a whole would be too. Similarly, when banks had many subsidiaries, regulators short of money and time tended to worry only about their own piece of the jigsaw.

This “micro-prudential” philosophy was always questionable. Now it looks absurd. Banks tend to own similar assets. In a crisis the capital of the entire industry tends to fall, which means that the instability of one bank can undermine the standing of the next. Hence the talk about a new “macro-prudential” sort of regulation that seeks to take account of the whole system’s vulnerabilities, as well as the health of individual banks, by, say, adjusting capital charges over the economic cycle.

The strengths of the original Basel standards (Basel 1) lay in being reasonably simple to negotiate and administer. But therein lay their weaknesses also. Banks soon started to favour business that was profitable (ie, risky) but which, under Basel 1’s crude definitions, escaped the appropriate capital charges. As the banks adapted to Basel 1, so the rules became less useful.

That gave rise to the effort to create Basel 2, which began in the late 1990s. This sought to strike a different balance, by asking banks to be more sophisticated in assessing the riskiness of their assets and thus their capital requirements. But sophistication came at a high cost. A recent book† by Daniel Tarullo, a professor of law at Georgetown University who is fancied for a senior economic post under Barack Obama, describes how the negotiations dragged on for years as governments jostled for a deal that would give their own banks some advantage. Mr Tarullo observes that the banks would accept all sorts of arbitrary provisions as long as the end result was to reduce the amount of capital they had to put aside.

Faults and lessons

Basel 2 is a flawed agreement. Although it is not yet in force, it already needs updating. Its chief failing is its reliance on rating agencies and the banks’ own models of the risks that they are carrying—an idea that has been discredited by the way banks have been caught out. In addition, the accord did not allow for the evaporation of liquidity that prevented the banks from financing their businesses. It is hardly reassuring that the minimum capital that rescued banks are aiming for today is far above the minimum set by Basel 2.

The story of bank-capital standards contains important lessons for the leaders gathering at the G20. The talks dragged on because their objectives were unclear, the subject matter was complex, negotiators were fighting for the upper hand and there was little sense of urgency. Even if all that can be put right, the schedule of work has expanded. Supervision may need to extend beyond banks, to any financial institution whose failure could threaten financial stability, which might include some large hedge funds and non-bank financial companies such as GE. The capital-standards regime also needs to become more macro-prudential. Regulators need to be able to put more trust in banks’ risk models and rating agencies and supplement them with simple rules about the level of borrowing. Mr Tarullo suggests that banks should issue new securities to serve as gauges of investors’ faith in them.

There are two difficulties in all this. The first is that it will take time and, as urgency fades and the negotiators drown in complexity, national interest may gain at the expense of collective safety. The second is that original dilemma: international rules require enforcement, but nation-states demand sovereignty. Dominique Strauss-Kahn, head of the IMF, wants an inspectorate. Mr Eichengreen has proposed a World Financial Organisation, with disciplinary panels. The EU wants “colleges” of national regulators for each bank and an IMF to give warning of crises. The summit looks most likely to back the EU idea—but it ought to be more ambitious. The system will work only if governments heed outside warnings. But just look at how they browbeat the IMF into giving favourable assessments of their economies.

Although this summit looks likely to dwell on financial regulation, it cannot ignore the macroeconomics that preoccupied the original Bretton Woods conference all those years ago. As Martin Wolf, a columnist at the Financial Times, explains in a new book‡, the boom was fuelled by the imbalances that grew out of the Asian financial crisis in 1997.

Countries that had grown used to incoming foreign capital suffered terribly when it suddenly flowed back out again. To protect themselves in future, they started to run current-account surpluses and to amass foreign-exchange reserves. Spendthrift America and Britain were happy to help Asia save, even if that meant running the corresponding deficits.

Surpluses are all very well, but they cannot continue to accumulate for ever. Perversely, if they unwind violently, they will create instability. Much of the cheap money recycled from the saving countries found its way into housing and other assets in the West. It was too much to hope that it would flow back out of those assets in an orderly way.

The conflict between sovereignty and safety here is even less easy to disentangle than it is in financial regulation. Clearly, no country would agree to live by a rule that it should balance its current account. Raghuram Rajan, a professor at the University of Chicago and a former chief economist at the IMF, points out that current-account surpluses and deficits can indeed help countries cope with shocks and finance investment. At the same time, no international organisation like the IMF could plausibly have the independence or the resources to make a credible promise to back all the economies suffering from capital flight in a crisis.

This conundrum leads straight back to a souped-up IMF—still too small to save the world, admittedly, but bigger than today’s, and backed by swap lines from the three large regional central banks, the Fed, the European Central Bank and eventually the People’s Bank of China. For that to work and for the IMF’s help to lose some of its stigma, rich countries will have to admit more emerging economies to the fund’s board. Cue yet more difficult negotiations.

There are two ways of thinking about this weekend’s summit in Washington. To be charitable, look on and wonder at the sheer ambition of taking on so many hard, important questions. A severe financial crisis may be the only time when the technicalities wallowing near the bottom of policymakers’ agendas receive the attention they deserve. But there is a more cynical interpretation. Perhaps the summiteers will bask in the headlines and then, out of the glare of the television lights, set about something disappointingly modest.

The Economist