Dear Friends,

As always, some of you made interesting comments on my Inflation note.

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May I infer that what you expect is significantly higher interest rates AND inflation significantly above 2 per cent? If so, other than writing a letter to our Congresswoman (who can’t vote) and perhaps buttonholing Barney Frank at your next Christmas eve party, what else? Could you write a second piece looking at investment strategies—what investments one might make to neutralize, or even benefit from, higher interest rates 2-3 years from now, raging inflation and a devalued dollar? All of your friends would be DEEPLY INDEBTED to you for this kind of advice. I’m refinancing my apartment, capturing 4.65 interest rates for 30 years. But what else?

Best,

Charles [Krause, Washington DC]

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So the answer is "maybe"?
Russ [Schrader, San Francisco, CA]

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Warren,

Nice to hear from you. I hope to visit that region of the world again at some point. Relaxing by the Dead Sea is no doubt nice, but so is dancing with the Dead! I’ve recently attended a few concerts by the remaining members of the original Grateful Dead who are on tour this spring.

The Dead began doing shows around 1966. For more than 40 years, presidents have come and gone while they just keep playin’ in the band, sharing their music with whomever happens their way.

They met briefly with President Obama during there stop-over in Washington. Probably moreso for Obama to pay homage to them, then vice versa. Someone associated with the band was quoted in the Post saying "there were no ties, and no tie-dyes." Ah, the Jeffersonian spirit lives. An extended hand of friendship with all, at least initially, and alliances with none.

There’s something about the scent of patchouli, the glow of fire in glass as the lights go out, the haze that engulfs a roaring crowd as the band takes to the stage, and the music of the ages that pours forth like a favorite wine.

How does any of that relate to the economy and inflation? The best things in life do not come from government, they are not expensive (although they are precious), and they are readily available to all who have ears and wish to hear, and all who have eyes who wish to see, in a manner of speaking.

Nero may have fiddled while Rome burned, but Rome had no business in Israel, and they never should have killed Jesus.

"I spent a little time on the mountain,

spent a little time on the hill.

saw some things gettin’ out of hand,

and I guess they always will…"

(from New Speedway Boogie, 1969)

David Garland [Richmond VA]

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Warren:

  Right on target!

Jim [Dorn, Cato Institute, Washington DC]

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Warren

Thanks for this.  Feldstein had a piece in the WSJ or FT yesterday giving a more pessimistic scenario about in inflation, and Volcker and Don Kohn got into a public verbal argument about it.

RWR [Richard Rahn, Great Falls VA]

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Dear Warren’

Many thanks for the insight. It was very helpful to me. I hope you are doing well….

Cheers

Tolga [Sobaci, Istanbul, Turkey]

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Hi Warren,

Very interesting article.

I hope I’m clever enough to buy long bonds when rates are way up, as they probably will  be at some point over the next 10 years…   if  we had bought 30-yr. bonds in Sept. or Oct. 1981, we’d still today be earning 15% per annum, that’d be wonderful!

Writing one’s congressman may not be enough, there may simply be too many powerful constituencies in favor (maybe without openly expressing it) of a sharp burst of debt-reducing inflation, or in favor of sustained not-extreme but not-so-moderate inflation (+5% per annum).

I do – sort of – remember the late 70s & early 80s, I was 10-15 yrs. old during that period. I remember going to Europe in 6th grade, my dad took me over for about three weeks, that must have been around 1979, and the dollar had recently reached a postwar low, I  remember how grumpy my dad was when I’d ask for walking-around money in London, hahaha and with 2,000 Ital. lira equaling a dollar, even at that tender (but no longer virginal) age, I somehow instinctively understood that this "goofy" exchange rate reflected past inflation, that the Italians hadn’t started out with a currency worth a tenth or a twentieth of a penny.   

Anyway, welcome back from Jordan.

Wolfie [Ernest McCall, Istanbul/Washington DC]

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Thanks Warren – a fantastic note! This is exactly what we are currently studying in my International Economics course (whether Fiscal policy has an effect on Monetary policy).

Hope all is well!

Best,

Alex

Alex Seleznyov

Georgetown University

McDonough School of Business class of 2010

[Almaty, Kazakhstan]

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Dear Warren,

Speaking of future inflation, have you read Greg Mankiw’s crazy article in Sunday’s New York Times ("Maybe the Fed Should Go Negative", NYTimes, April 19, 2009:  http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1). 

After reading it, I was reminded of Lord Acton’s statement, "There is no error so monstrous that it fails to find defenders among the ablest men."

Basically Mankiw advocates a partial (10%) repudiation of Federal Reserve Notes in a desperate effort to get the public to buy Treasuries that pay negative interest rates.  He believes this extreme measure is necessary to jump start the economy and reignite inflation, his ultimate goal.  Each year he would have the Treasury choose a random 10% of all banknotes and repudiate their legal tender status as a way to encourage people to buy T-bills that pay less at maturity.  

That’s got to be one of the most dangerous policy ideas since Keynes endorsed Silvio Gesell’s "stamped" money idea and "zero money rate of interest" …Keynes himself labeled Gesell a "crank" (General Theory, pp. 353-57).  If enacted, Mankiw’s dollar repudiation idea would surely panic the public into withdrawing billions from bank accounts and into gold. 

With hair-brained schemes like this one, I can see why the country is losing faith in its government and economics profession.  And this is coming from the #1 econ textbook writer! 

It’s highly doubtful the Treasury would adopt Mankiw’s crazy idea, but it won’t enhance Mankiw’s reputation as a sound thinker. 

I’ve known Greg for many years and have told him that he’s making a serious blunder that will come back to haunt him. 

BTW, in the same New York Times yesterday, they had a sample AP exam in econ.  Amazingly, I got a "5" point scale ("extremely well qualified").  You can take the quiz online by going to:  http://www.nytimes.com/interactive/2009/04/19/education/edlife/20090419EdlifeQuiz.html?scp=1&sq=economics%202009%20ap&st=cse

Best wishes, AEIOU,

Mark [Skousen, NY]

In reaction to the financial and credit crisis that seized American and international financial markets last September, the Federal Reserve has pumped enormous quantities of credit into the market in an effort to unblock clogged credit flows. The Fed creates this credit out of thin air, or as Fed Chairman Bernanke put it, it is printing money. Knowing that inflation is ultimately the result of the central bank (the Federal Reserve) printing too much money, many people are concerned that the Federal Reserve’s recent and current policies doom the U.S. and the dollar to serious inflation in the next few years. This note reviews the historical relationship between the growth in the money supply and prices (inflation) and the recent behavior of the money supply, and presents my assessment of the prospects for inflation over the next few years.

The simplest analytical framework for understanding inflation is the quantity theory of money. This framework may be presented in two different ways. As economists prefer to think of price determination in terms of supply and demand, our preferred formulation of the theory says that the value (purchasing power) of money (“the price level” P) results from its supply (M) relative to its demand and that (as the simplest assumption) its demand is proportional (k) to real output (real GDP–q) or M = kqP. An increase in the supply of money (M) will cause prices to raise (P) until the demand for money (kqP) matches the increase in its supply. Both theory and evidence says that the money supply has no long run effect on real output (q), thus ultimately the entire effect of money growth is on the price level (CPI).

Thus inflation (which is the rate of change or growth rate of the price level) reflects the growth rate of the money supply or ΔM = Δq + ΔP (where k is constant, q is independently determined by growth in labor, capital and productivity, and Δ is the change from one period to the next in whatever it refers to). Hence inflation is determined by the economy’s real economic growth rate and the growth rate of the money supply:

ΔP = ΔM – Δq.[1] If the economy is growing at 3% per year and the money supply is growing at 5% per year, inflation will be approximately 2% per year. However, historical evidence reveals a lag of one to two years between changes in money growth rates and inflation. If money growth increases to say 10%, the impact on inflation would not materialize for another one to two years.

Instead of the demand for money formulation described above, the quantity theory of money is sometime presented in term of money’s velocity of circulation (V): MV = Pq. The two versions are equivalent (V = 1/k). The key point is that with a lag of a year or two increases in the rate of growth of the money supply cause a comparable increase in inflation.

These are long run relationships. In the short run other factors can dominate the behavior of inflation. In the long run a reduction in the economy’s growth rate (Δq) increases the inflation rate resulting from a given rate of growth of the money supply. However, in the short run if real income growth slows or even falls (with no change in its long run potential growth rate) it has the opposite effect on inflation. Economists refer to this as the output gap (between real output and potential or full employment output). When actual output falls below its potential, as occurs during recessions, inflation is reduced for a given rate of growth in the money supply (the demand for money—k—increases temporarily).

Our central bank–the system of Federal Reserve Banks–indirectly controls the money supply (currency held by the public and the public’s deposits with banks) and its rate of growth. There is a link between the money created by the Fed (called base money) and the broader money supply (M). The two are related by the so called the “money multiplier.” Usually the money supply grows at about the same rate as base money.

With these ideas in mind the huge injection of liquidity by the Fed is worrying many people. The Fed has increased base money as a result of large loans to banks and other financial institutions and as the result of buying government securities and mortgage backed securities from the market. By two measures the increase has been huge. Total Federal Reserve Credit has more than doubled over the last year from 0.90 trillion dollars on April 11, 2008 to 2.15 trillion on April 15, this year. Almost all of that increase occurred since September. As a result, base money almost doubled over the same period, rising from 874 billion Sept 10, 2008 to 1,726 billion March 25^th of this year.

The Federal Reserve argues that this will not cause inflation for two reasons. First, the large increase in the provision of Federal Reserve Credit and base money was undertaken because of a large increase in the demand for liquidity by banks and other financial institutions in response to the subprime mortgage crisis. Thus doubling base money has not increased the money supply by nearly as much. Using a popular, relatively broad definition of money (MZM), the money supply rose from 8.6 trillion on April 7 2008 to 9.4 trillion on April 6, 2009. Stated in terms of growth rates, which can be directly related to inflation rates, the growth in MZM over the past year (year on year) was 9.7%. This is already significantly reduced from the year on year increase of 14.5% on January 19^th of this year and only modestly above the 8.7% average annual rate of growth over the decade ending December 2008 during which inflation averaged 3.0% (the demand for money, k, grew about 2% per year on average over this period).

Secondly, the Fed estimates that over the past year the public’s demand for money has increased temporarily as the public “moved to safety” in the holding of its assets (currency and insured bank deposits). An increase in money demand (k) or equivalently a decrease in its velocity of circulation (V) means that the supply of money can grow more rapidly to that extent without increasing inflation. In addition, the recession with its increasing “output gap” further reduces inflation (temporarily).

Finally, the Fed intends to withdraw the extra liquidity it has injected (and thus reduce base money) as the credit crunch eases and the economy begins to recover. It remains committed to its target for inflation of around 2%. Thus the answer to the question of whether Fed policy will produce inflation in a year or two depends primarily on whether it successfully withdraws the large amounts of liquidity injected over the past six months. I have confidence that it will be able to do so more or less (but not exactly) at the right time and pace.

The real risk of inflation, however, is political. The Federal budget has unfunded liabilities (the difference between the cost of the benefits promised and the revenue now legislated to pay for them) that simply cannot be paid for. The Federal budget deficit expected over the next three or four years as a result of the financial crisis, recession and foreign wars of several trillion dollars is nothing compared to the present value of the government’s unfunded obligations to pay out Social Security benefits of about 13 trillion dollars. The present value of unfunded liabilities of Medicare commitments’ is six time (yes six times) that. It is not possible to raise taxes enough to cover these commitments. Promised benefits will have to be cut. Invariably tax rates will be raised as well and the slowing of economic growth resulting from all this will make the burden of these deficits even harder to carry. In addition, the rest of the world will not continue to finance as much of our annual deficits (and thus to own as much of the outstanding debt) as they have in the past, i.e. the market will force our external trade deficits to contract.

All of this adds up to higher, potentially significantly higher, interest rates in the years ahead (once we have recovered from the current recession) to enable the government to raise the money needed (sell its bonds) to finance its revenue shortfalls. Just how high interest rates will raise will depend on how much government spending can be cut and future entitlement promises reduced, how efficient and productive the economy will be and thus how high its growth rate will be, and how large a trade deficit the rest of the world lets us have.

“Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road.”[2] The short run effect of monetary growth is the opposition of its long run effect. Increasing the Fed’s creation of money initially pushes down interest rates as it buys more government securities or increases its lending to banks. However, as the higher money growth rate increases inflation, higher expected inflation gets build into new borrowing and lending interest rates pushing rates up eventually.

Current monetary policy does not need to result in higher inflation down the road. But the higher interest rates we are in for risk generating misguided political pressure on the Fed to try to keep them low. If the Federal Reserve gives in to the pressure, inflation will be higher and as soon as the economy comes to expect that higher inflation nominal interest rates will end up being even higher still. Try to remember the inflation and high interest rates of the 1970s through 1981 and tell your congressman to resist the inflation solution.

Introduction[1]

The U.S. dollar is the world’s primary international reserve currency. Most international payments are made in dollars, many globally traded commodities (such as oil) are priced in dollars, and almost two thirds of the world’s official (government owned) foreign exchange reserves of 6.7 trillion dollars are held in dollars. The only other important currency in foreign exchange reserves is the Euro with 27% of the total.

When central banks want to increase the size of their foreign exchange reserves (as most did after the Asian financial crisis in the late 1990s) they will largely want to do so in dollars and this will result in (only be possible from) larger than otherwise U.S. trade deficits. The U.S. trade deficit is the means by which the rest of the world accumulates the dollars it wants. This arrangement and the global imbalances it sometime promotes has long been a source of concern.

Both the Governor of the Peoples Bank of China (China’s central bank) and the President of Russia have recently called for the ultimate replacement of the U.S. dollar as the world’s reserve currency with one issued by the IMF (the Special Drawing Right—SDR).[2]^,[3]  The SDR was created in 1969, just before the collapse of the Bretton Woods international currency system, precisely for this purpose. With the abandonment of the gold exchange standard and the floating of the dollars exchange rate in 1971, the need for SDRs became less pressing. The G20 heads of state meeting in London in early April called for an additional $250 billion dollar allocation of SDRs, almost an eight fold increase over the current stock of $32 billion.

Special Drawing Rights

Most people have forgotten what SDR’s are (if they ever knew). Like dollars or any other currency, the SDR is both a unit of account and a means of payment. The value of the SDR was originally defined as the market value of 0.888671 grams of fine gold, which in 1969 was equal to one U.S. dollar. Currently one SDR is the market value of a basket of 0.632 U.S. dollars, 0.41 Euros, 18.4 Japanese yen, and 0.0903 Pound sterling. At the time the current basket was adopted (January 1, 2006—its valuation basket or method of valuation is reviewed and adjusted every five years) these amounts reflected weights of 44 % for the U.S. dollar, 34% for the euro, and 11% each for the Japanese yen and pound sterling. Over time these weights vary with the exchange rates of the fixed currency amounts in the basket. The U.S. dollar values of the amounts of each currency in the valuation basket are determined in the market each day and added up to determined that day’s value of the SDR (see the table below).

All of the IMF’s financial activities, in particular its loans, are valued in SDRs. These SDR denominated loans are not SDRs proper any more than U.S. Treasury bonds are U.S. dollars proper. The SDR amount of credit due to the IMF varies over time as its lending activity varies. IMF loans are actually disbursed to borrowing central bank largely in member currencies (primarily U.S. dollars), but the obligations are denominated in SDRs.

What we might call the SDR proper, the SDR denominated reserve asset allocated by the IMF—the SDR the Governor of the Peoples Bank of China was referring to, has played a very limited role to date. The IMF has only issued SDR 21.433 billion of them (the equivalent of about 32 billion U.S. dollars at current exchange rates). For perspective, this might be compared with the amount of credit directly created by the Federal Reserve (Federal Reserve Credit) of about $2 trillion dollars or the 250 billion U.S. dollar allocation (as the creation of SDRs is called) proposed by the G20. The new allocation, by raising the stock of SDRs from 21.4 billion to $271.4 billion, will provide a very big boost to the SDR.

An SDR allocation is similar to a line of credit. The 250 billion in new SDRs will be “allocated” to IMF members in proportion to their quotas in the IMF, which roughly reflect their economic size and importance in world trade. Bulgaria, for example, with a quota currently of 640.2 million SDRs, which is 0.29% of the total (financial) size of the IMF, would receive an allocation of 725 million SDRs (250 billion times 0.29%). These will be credited to Bulgaria’s SDR account with the IMF as additional SDRs owned and held by Bulgaria. At the same time Bulgaria’s SDR account with the IMF will record a liability for the same amount. Bulgaria will earn interest at the SDR interest rate on what ever SDRs it holds[4] and must pay interest at the same rate on its SDR liabilities. If it continues to hold the SDRs it was allocated, Bulgaria will earn the same interest income that it pays on its allocation.[5] In short, if it does not use any of its SDRs and does not acquire additional ones in payments from other IMF members or other holders or buy them, its interest income on its SDR holdings and payments on its net cumulative allocations will be equal and will thus cancel out. Bulgaria will enjoy larger foreign exchange reserves at no cost (but with no net interest return). If Bulgaria uses 100 million of its SDRs, its interest income will fall by that amount times the SDR interest rate, but its charges for its net cumulative allocation will remain unchanged (other than from changes in the SDR interest rate). In short, Bulgaria would then have a net charge to the extent of its use of its SDRs. This is the sense in which an SDR allocation is like a line of credit (without the commitment charge or risk of cancelation). Conversely, if Bulgaria acquires additional SDRs from other central banks so that its holdings of SDRs exceed its net cumulative allocation, it will enjoy net income to that extent at the SDR interest rate.

If the demand for SDRs equals or exceeds their supply, countries could use their SDRs directly. The Chinas of the world, with foreign exchange reserves of $2 trillion (mostly in U.S. dollars), would be happy to accept and hold them in payment for another country’s financial obligations or to buy them (rather than dollars) for dollars that the selling country could use to settle obligations with someone else unable or unwilling to accept SDRs. For the past twenty five years virtually all SDRs have been used in this way. Most countries using their SDRs first converted them into dollars by selling them for dollars to another central bank in so called “Transactions by Agreement.” However, the system also has a mechanism, so called “Transactions with Designation,” by which countries with a strong balance of payments can be designated to buy SDRs for dollars, or Euros (or another freely useable currency) when a holder wishing to sell them for currency cannot find a buyer in a Transaction by Agreement. With the huge allocation now being proposed, it is likely that some users will again need to resort to this obligatory purchase requirement for a while.

Global imbalances

Twenty years ago as the Berlin Wall came tumbling down the United States imported $580 billion worth of goods and services from the rest of the world (1989). This was about 11% of U.S. domestic production (GDP). The U.S. paid for most of that by exporting $487 billion worth of goods and services. The shortfall (trade deficit) of $93 billion was more than paid for by the net income received by American’s from their investments abroad. This modest trade deficit of 1.7% of GDP rose to an unsustainable 5.7% of GDP by 2006. The gradual depreciation of America’s overvalued dollar over the last few years has begun to correct this global imbalance and this last year (2008) saw a reduction in the U.S. trade deficit to the still very high level of 4.7% of GDP. Though American imports continued to grow (to almost 18% of GDP in 2008), its exports grew more rapidly over the last few years thus replacing some of the lost consumer spending as households starting to pay off excessive debt and to rebuild their savings. This desirable correction has been temporarily interrupted by a global recession and creeping protectionism in the U.S. and elsewhere.

These large global imbalances contributed significantly to the U.S. housing bubble and the financial crisis it created. Large U.S. trade deficits (the U.S. imported much more than it paid for with exports) financed largely by Chinese and Japanese trade surpluses invested in the U.S. (largely U.S. Treasury bills and bonds) kept interest rates in the U.S. low despite large U.S. government deficits and very low household savings rates. Excessive borrowing and housing demand in the U.S. resulted.

The rapid increase in world wide trade (globalization) over the last several decades benefited American consumers and workers world wide (including in the U.S. where unemployment reached historically low levels). But U.S. trade imbalances (the mismatch between imports and exports and the balancing capital flows to the U.S.) reached unsustainable levels and will have to contract. There are limits to the number of U.S Treasury bills the Peoples Bank of China is willing to hold (it still continues to add to that number but at a slower rate). There is also a limit to the amount of debt the U.S. Treasury can service (pay interest on) and financial markets have already begun to reflect a higher (though still low) probability of U.S. default on its huge and rapidly growing public debt.

The lowering of tariffs and other trade barriers (e.g. transportation costs) permitted this rapid growth in trade, which doubled the incomes of a third of the world’s population, something aid could never have accomplished. Why then didn’t markets operate to limit trade imbalances to sustainable levels? The failure reflects the failure of government policies in China and the U.S. and elsewhere to play by the rules of international finance and the accumulation of the U.S. dollar in international reserve holdings made this failure easier.

When a country buys more from the rest of the world (imports) than it sells to the rest of the world (exports), it must borrow from the rest of the world to pay the difference (or use its reserves of foreign currencies). If the rest of the world is not eager to lend or otherwise invest in the borrowing deficit country, exchange rates will adjust in international currency markets (or the “real exchange rate” will adjust via domestic inflation or deflation). The simple market reality is that consumers tend to buy where they get the best deal (price and quality mix). When comparing a product of comparable quality produced in China verses the same product produced in Indiana, the price to an American is the dollar cost of producing it in and shipping it from Indiana or the Chinese Renminbi cost of producing it in and shipping it from China times the exchange rate between the Renminbi and dollar. The exchange rate plays a critical role in determining the cost of American exports to the Chinese or of Chinese imports to Americans. Thus the statement that Chinese labor is cheap so of course they can sell it to Americans cheaper, is half (the exchange rate half) meaningless and totally wrong.

The rule of international finance with regard to exchange rates is that governments should not interfere with this price (exchange rate) adjustment process. The market process for maintaining the desired external balance can be illustrated with examples from two opposite exchange rate regimes. The gold standard, the most recent and most important global currency and a the time tested example of a fixed exchange rate regime, and a freely floating (market determined) exchange rate with a domestic inflation or monetary aggregate target.

If two countries (or the whole world) are on the gold standard, the exchange rate of their currencies for each other are determined and fixed by the prices (exchange rates) of each of their currencies for gold. The rules of a pure gold standard, like those of modern currency boards (e.g. Bosnia, Bulgaria, and Estonia), require that the monetary authority passively provides its currency for gold (at the officially fixed price of gold) or gold for its currency (buying it back) as demanded by the market. With open and free trade, this system insures that the market produces and maintains balanced trade between these two countries (or the whole world). Balanced trade here mains a trade surplus or deficit (exports minus imports) just sufficient to satisfy the net desire of residents to invest abroad (investment abroad minus foreign investment at home). Let’s leave this complication aside and assume that markets desire on net to invest in their own countries so that market forces produce a balance between imports and exports and let’s stick with the example of the U.S. and China representing the rest of the world. How does the gold standard produce balanced trade?

The mechanism can be most easily explained be starting with a balanced situation (equilibrium) and introducing a disturbance. If the value of American exports to China equals the value of America’s imports from China at the fixed exchange rate between their currencies (via the gold prices of each), the sudden discovery of oil in China (or an increase in the price of oil where the U.S. is an oil importer) would raise the value of American imports from China. This introduces an imbalance in their trading relationship (an American trade deficit). The U.S. is no longer able to pay for all of its imports with exports. If must pay for the more expensive oil with gold (any dollars sold by American importers for Renminbi that are not wanted by Chinese importers to pay for their imports will be sold to the American central bank for gold). This outflow of gold from the U.S. reduces the money supply in the U.S., which lowers the average price level in terms of dollars (the value of dollars and gold are increased relative to American goods and services). This process makes Chinese goods relatively more expensive to American’s, who will thus import less and American goods relatively cheaper to Chinese, who will thus buy more of them. Gold flows out and the U.S. money supply and dollar prices of American goods and services fall until balance is restored between imports and exports (with the higher price of oil).  No unsustainable global imbalance is possible (other than temporarily while the “real” exchange adjusts as described above) as long as neither country’s central bank interferes with this process.

Taking the same example of an oil price increase, but with a freely floating, market determined exchange rate, the adjustment in the real exchange rate that the market demands takes place via a depreciation in the nominal exchange rate of the dollar for the Renminbi (i.e. an appreciation of the Renminbi). In this case the surplus of dollars in the foreign exchange market described above cannot be sold to the American central bank as was the case with the gold standard. As a result the excess supply in the foreign exchange market drives down the price of the dollar relative to the Renminbi. Under both regimes the real exchange rate adjusts as required to restore trade balance. An unsustainable global imbalance is not possible unless one or the other central banks intervenes in the process.

Normally to import a country must sell its currency in the foreign exchange market for the currency of the country whose goods and services it wants to buy. Similarly when some of its companies export they will only accept payment in their own currency, which requires the country buying them to sell its currency in the foreign exchange market for the currency of the exporter. The U.S. is unique in this regard because it issues the reserve currency of the system. Other countries will accept and sometime hold dollars when they sell their goods and services to the U.S. or to other countries. If they do not use these dollars to import (from the U.S. or other countries) they will invest them in the U.S. buying U.S. securities (often government securities), U.S. companies or shares in companies or even real estate.

The U.S. and China (to continue with our two country example) have interfered in the market’s natural equilibrating tendency in two ways. China has not wanted to let its currency appreciate against the dollar because its rapid growth is largely driven by exporting (foreign demand) and an appreciation would reduce foreign demand for Chinese exports. Thus the Peoples Bank of China (its central bank) intervened in the foreign exchange market to buy up the excess dollars resulting from China’s trade surplus in order to keep the exchange rate of its currency constant (or to slow its appreciation). When the Peoples Bank buys dollars it does so with its own currency. Under the rules of the game, if the Peoples Bank wants to peg its nominal exchange rate it must allow the increase in the supply of Renminbi in China and the Renminbi inflation it would cause when it buys dollars in the foreign exchange market. However, the People’s bank has resisted this alternative means of appreciating the real exchange rate of its currency through what economists call sterilized intervention. The Peoples Bank prevents the increase in its money supply caused when it buys dollars by buying the Renminbi back through the use of other central bank policy instruments (such as selling Chinese government securities and retiring the Renminbi received for them)—hence the term “sterilized” intervention.

The U.S. for its part has kept interest rates higher than they otherwise would be by running large fiscal deficits and as a result of very low private sector savings rates. Such rates encourage China and other countries to invest more in the U.S. than they otherwise would. China points attention to this U.S. pull of foreign investments into the U.S. The U.S. points to the Peoples Bank’s sterilized intervention and undervalued exchange rate as pushing investment into the U.S. of its resulting increase in foreign exchange reserves. The fact that China’s exchange rate policy has resulted in rapid and large increases in its foreign exchange reserves (U.S. dollars) has pushed so much into U.S. investments that U.S. interest rates remained low despite low savings rates and fiscal deficits.[6]

A Future for the SDR?

In the above examples, if the SDR replaced the U.S. dollar as the international reserve asset, any dollars purchased by the Peoples Bank to preserve its nominal exchange rate (as in the gold standard example) would be sold to the U.S. for SDRs. It would hold SDRs rather than dollars in its reserves. The U.S. could no longer print dollars (issue Treasury securities) to satisfy China’s demand for reserves. If its holdings (reserves) of SDR’s ran short, it would need to allow the upward pressure on its interest rates in order to increase capital inflows to provide it with the SDR’s demanded by China. The market adjustment mechanism would work as described above.[7] It would be more difficult for the U.S. to undermine the global balance adjustment mechanism as it does now.

The key advantages of the SDR over the U.S. dollar (or any reserve currency issued by a national central bank) are that its value is more stable relative to currencies in general (being a currency basket)[8], its supply is determined by collective decision of the IMF’s member countries, it is added to each countries’ reserves (to the extend of each countries allocation) without cost (now countries must sell their goods and services to acquire additional net foreign reserves), and the global supply can be increased without the need for a current account (or trade) deficit by the issuing country. These are formidable advantages.

Getting from here to there will take more than additional allocations of SDRs, though that will be part of the evolution. Most central bank reserve transactions are not with other central banks. They are with the market. The Peoples Bank of China buys dollars in the foreign exchange market (i.e. from banks and other foreign exchange dealers) and uses them to buy U.S. government securities in American markets (not from the U.S. Treasury directly). Thus the acceptance and growth of the “official” SDR (those allocated to central banks by the IMF), will require the development of private ones (private SDR denominated financial instruments) and mechanisms for linkages between the private and the official ones.[9] This was the path followed by the Euro (and its predecessor the Ecu).[10]

The extent to which the world chooses to hold and deal in SDRs rather than dollars will reflect the extent to which individuals and governments are more confident in the valuation of the SDR than the dollar or other possible units and the convenience (cost) of dealing in the asset. The world has changed its reserve currencies from time to time to align with the dominant economic power of the time, but such changes have always been gradual. If the SDR catches on, its displacement of the dollar would also be gradual, taking place over many years of growing use.

An important advantage of an international currency like the SDR emphasized by People’s Bank Governor Xiaochuan is that the U.S. would be subject to much stronger market pressure (in the form of exchange rate adjustments) that would maintain better balance between imports and exports than is now the case. The U.S. would also face far less risk of the central banks of the world losing confidence in the dollar and sharply reducing their willingness to hold them. As the SDR does not and is not likely ever to exist in currency form, the U.S., and increasingly the E.U. are likely to continue to enjoy the seniorage profits from selling their currency to the citizens of rest of the world.

Bibliography

Warren Coats, "The SDR as a Means of Payment," IMF Staff Papers, Vol. 29, No. 3 (September 1982) (reprinted in Spanish in Centro de Estudios Monetarios Latinoamericanos Boletin, Vol. XXIX, Numero 4, Julio–Agosto de 1983).

            "SDRs and their Role in the International Financial System," International Banking and Global Financing, proceedings of a Conference held at Pace University, New York City, May 1983.

            With William J. Byrne, "The Special Drawing Right:  Composite Currencies: SDR, ECU, and Other Instruments," Euromoney, 1984.

            With Jacob Gons, Thomas Leddy, and Pierre van den Boogaerde, "A Comparative Analysis of the Functions of the ECU and the SDR," in The Role of the SDR in the International Monetary System, Occasional Paper No. 51 (Washington, D.C., IMF) (March 1987).

            "Enhancing the Attractiveness of the SDR," World Development, Vol. 18, No. 7 (July 1990).

            With Reinhard W. Furstenberg and Peter Isard, "The Use of the SDR System and the Issue of Resource Transfers?," Essays in International Economics, International Finance Section, Department of Economics, Princeton University, No. 180 (Dec. 1990).

            "Developing a Market for the Official SDR," Current Legal Issues Affecting Central Banks, Volume 1, International Monetary Fund (Washington, D.C.) May 1992.

            "In Search of a Monetary Anchor: Commodity Standards Reexamined," in Framework for Monetary Stability, ed. by T. J. Baliño and C. Cottarelli , (Washington: International Monetary Fund, 1994).

Dmitry A. Medvedev, "Building Russian–U.S. Bonds" The Washington Post, March 31, 2009, Page A17.

Zhou Xiaochuan, "Reform the International Monetary System", Website of the Peoples Bank of China, March 23, 2009.

“The board that sets U.S. accounting rules voted yesterday to let financial firms report higher values for some troubled assets, a controversial step likely to increase some banks’ reported earnings but also heighten suspicions that the companies are concealing problems.”[1] The vote Thursday by the Financial Accounting Standards Board (FASB) is a very bad development for several reasons.

1. The FASB caved in to very ill advised pressure from Congress to rush through this dilution of accounting standards, thus undermining the independence and professionalism of the Board.

2. While we don’t know the details, because the new ruling has not actually been written yet, a key lesson from Japan’s lost decade and every other major banking crisis of the last century is that denying or hiding bank losses is a big mistake. “This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle. To break this cycle, the government must force the banks to acknowledge the scale of their problems.”[2] Thus the FASB’s ruling is a step backward. It will undermine market confidence in banks further and make the resolution of the problem harder and slower.

3. If banks can record higher values for some of their assets (especially mortgages and Mortgage Banks Securities) it is much less likely that they will sell them to other investors under the Treasury’s new toxic asset purchase scheme, because they will then need to value them at the actual (lower) sale price. When assets are actually sold, mark to market accounting will still apply. One arm of government is undercutting the policies of another.

Arthur Levitt, a former chairman of the SEC said, "I was very disappointed in the process in that the independent agency buckled to the strong-armed tactics of Congress, This is a step toward the kind of opaqueness that created the economic problems that we’re enduring today."[3] “If investors believe banks are overpricing assets, "the capital markets will remain closed to major banks and other financial intermediaries for an extended period of time," the CFA Institute, an investor advisory organization, said in an analysis. The group, which opposed the change, said "investors will not be willing to commit capital to firms that hide the economic value of their assets and liabilities."[4]

This is a potentially dangerous mistake.

[1] Binyamin Appelbaum and Zachary A. Goldfarb, "Under New Accounting Rules, Toxic Assets May be Revalued", The Washington Post, April 3, 2009, Page A15.

[2] Simon Johnson, "The Quiet Coup–The Way Out", The Atlantic, May 2009.

[3] Op. cit., Appelbaum and Goldfard.

[4] Ibid.

Hi all,

As usual, many of you had interesting comments on my March 19^th note on the AIG bonus scandal. Louise (my former wife) replied: “Thank you for the thoughts.  I just can’t buy these arguments.” She no doubt reflects widely held attitudes about these bonuses, corporate remuneration more generally, greed and excessive risk taking by financial sector players, and the government’s role in the mess (at least I hope that there is public anger over that too). My Bulgarian friend Nedialko Dumanov (a banker) raised questions in his reply that give me a second shot at explaining my own outrage. His note and my reply are followed by some additional comments by some of you. Thanks so much.

***************************

Hi Warren,

First for AIG bonuses – it is a crime. Bonuses for bringing a company to bankruptcy! Retention bonuses – it is funny. If these managers were wise and smart why does the company need hundreds of billions governmental aid?! How could people who produced huge loss could be valuable employees?!

Where is the free market economy? What about competition and comparative advantages of countries? Why should companies who did not performed well and made huge losses be given hundreds of billions, which they will waste as they did with the previous billions?!! It is terribly stupid to give money to someone who has proved that he can not manage them properly!

If I had US dollars I would sell them immediately.

Nedialko [Bulgaria]

****************************

Dear Nedialko,

The retention bonuses were not for AIG management. They were for employees expected to leave AIG’s sinking ship to work for competitors who were thought to be vital to efforts to contain the losses the products they created were causing. As a shareholder of a company I would want to pay what it takes to employ people who increase the long run profits of the company by more than they are paid (thus increasing the value of my shares). If their remuneration takes the form of part salary and part performance bonus, that might work even better. However, the use of bonuses has clearly gone wrong in some, maybe many, cases by focusing too much on short term performance and by creating incentives to fudge the accounting. The remuneration of top management sometimes seems grossly excessive as well.

When AIG reported a $11.5 billion in annual losses for 2007, it also announced the resignation of Joseph Cassano (the guy most responsible for those losses) as head of AIG’s Financial Products division, “saying an auditor had found a "material weakness" in the CDS portfolio. But amazingly, the company not only allowed Cassano to keep $34 million in bonuses, it kept him on as a consultant for $1 million a month. In fact, Cassano remained on the payroll and kept collecting his monthly million through the end of September 2008, even after taxpayers had been forced to hand AIG $85 billion to patch up his fuck-ups. When asked in October why the company still retained Cassano at his $1 million-a-month rate despite his role in the probable downfall of Western civilization, CEO Martin Sullivan told Congress with a straight face that AIG wanted to "retain the 20-year knowledge that Mr. Cassano had." (Cassano, who is apparently hiding out in his lavish town house near Harrods in London, could not be reached for comment.)”[1]

What can and should be done about such abuses? I believe in letting supply and demand set the price (remuneration package) as long as competition is unimpeded. Imposing limits/caps on what the market can pay when supply and demand would set a higher price is rarely successful. If a firm wants someone and is not able to pay the salary/bonus needed to get him or her, it is hard to prevent the two from finding some other (equivalent but less efficient) way to reach a deal. Babe Ruth and Steve Jobs are unique and worth paying almost anything to get. But such cases are extremely rare. There are dozens of very talented men and women who are able to do outstanding jobs at leading Citibank, GM, or Microsoft. It is very unlikely that one of them is so uniquely qualify relative to the others to be worth $34 million per year. So what has gone wrong in the market?

Managements sometimes appear to be enriching themselves at the expense of owners. Something is wrong with my rights, or the use of them, as a shareholder to evaluate and control management (and employee) remuneration. Corporate governance needs strengthening. There may be other sources of this problem as well. Let’s see what we can learn from the current experience.

Within weeks of its first public disclosure of losses in February 2008 AIG’s compensation committee offered retention bonuses to several hundred Financial Products division employees. Later AIG’s new, government appointed boss, Edward Liddy, argued, as I stated in my previous note, that these employees were important for negotiating the unwinding of Credit Default Swaps they had created. Without them, he argued, the liquidation of the Financial Products division could cost tax payers much more. I am in no position to evaluate the veracity of Mr. Liddy’s claim, but it seems plausible to me that the guys who made the deals are the best ones to undue them.

More alarming than the public’s reaction to AIG’s retention bonuses was the reaction to how AIG used the $173 billion received from the government. Serious questions have been raised about the need to bailout AIG (actually its separate Financial Products division, as its insurance units are fine) in the first place, but the reason, justified or not, was that its failure could spread losses to other creditor financial institutions causing a cascading domino of failures the economy could not easily absorb. Thus it should not be surprising that much of AIG’s bailout cash went to honor its obligations to other financial institutions. At the top of the list of beneficiaries was good old Goldman Sachs. However, it was the large payments to foreign banks (Societe Generale, Deutsche Bank, UBS, Barclays, BNP Paribas) that drew the most criticism. U.S. entities, including the U.S. government in a very big way, receive hundreds of billions of dollars of financing from foreign banks, governments and others every year. If these foreign lenders suspected that their repayments were in doubt—that, for example, American banks (or the likes of AIG) would discriminate against and not fully honor their obligations to foreign lenders, the American financial system would collapse. It really would be another great depression. The American government would be forced into default on its huge debt as no one would be willing to buy it or hold what is already out there. No one would finance stimulus packages, bailouts, or wars in Iraq and Afghanistan, much less the regular parts of the budget that exceed tax revenue.

The congress that (perhaps) foolishly authorized the funding for these bailouts in the first place began stomping its feet (rather too late) demanding its (our) money back. Fine, but to seek to deny payment to people who had already done the work they promised to do or to tax it all away after the fact was a series and damaging over reaction, though tax payers did seem to want to punish AIG employees even if it cost them more in higher taxes because of higher bailout costs. “White House Chief of Staff Rahm… Emanuel said that although the anger of the public and Congress is understandable, ‘everybody woke up the next day, took a deep breath and realized, let’s not govern out of frustration.’”[2] Thank God for that.

I urge you to read Robert J. Samuelson’s column "American Capitalism Besieged", in today’s Washington Post. Here are two quotes from his op-ed piece:

“Schumpeter, one of the 20th century’s eminent economists, believed that capitalism sowed the seeds of its own destruction. Its chief virtue was long-term — the capacity to increase wealth and living standards. But short-term politics would fixate on its flaws — instability, unemployment, inequality….

“But Schumpeter’s question remains. Will capitalism lose its vitality? Successful capitalism presupposes three conditions: first, the legitimacy of the profit motive — the ability to do well, even fabulously; second, widespread markets that mediate success and failure; and finally, a legal and political system that, aside from establishing property and contractual rights, also creates public acceptance. Note that the last condition modifies the first two, because government can — through taxes, laws and regulations — weaken the profit motive and interfere with markets.

“The central reason Schumpeter’s prophecy [that capitalism would not survive] remains unfulfilled is that U.S. capitalism — not just companies, but a broader political process — is enormously adaptable. It adjusts to evolving public values while maintaining adequate private incentives.”

Best wishes,

Warren

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Yeah, this is a lot of hot air, and it’s largely stupidity if not outright demagoguery.  If someone pays me a “bonus” to ensure that I stick around and I do stick around, they damn well better pay up.  If AIG management thought it prudent to make such commitments to employees contingent on nothing else but the always implicit avoidance of bankruptcy, then they have to live with it.  If the current shareholders — now largely the U.S. government — think that was irresponsible, they can fire or otherwise penalize those managers.  That horse, however, has largely left the barn since the government asked Mr. Liddy to come out of retirement to keep AIG from careening into bankruptcy.  Instead of having AIG-FP folks commit hara-kiri, as Sen. Grassley so obscenely suggested, America would do better to have a few dozen members of Congress fall of their own swords, very real swords.  And if they don’t have swords, a quick jump from the top of a House or Senate office building would suffice.

[Kelly Young, Washington DC]

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Hi Warren

I think you are right about what you said.   But the distaste for the actions that Congress has had to face over the last few months trying to control what has happened I think has frustrated so many of the Members.  Had the Treasury for example gone up to Congress early and laid out the issues it was facing to Members like my old boss Chuck Grassley and explained it to him I don’t think you have had him go off the way he did.  Here you have one of the tight fisted guys I have ever met… and the stories I could tell you about that would make you laugh for weeks.  As it doesn’t make a difference if it’s his money or the governments money (he has returned over $100,000) a year from his office budget which we often told him by doing that it is then used for those that go over their budgets each year, it has never made a difference to him, he did not spend the money. 

For him to be voting for some of these bail outs goes completely against his grain.  Then to find out from the press that a company like AIG was giving out those size bonus’s to people that ran the company into the ground and at the same time expecting billions in tax payers money because they are too big to go under it does not make since to reward them.  They should be I am sure in his mind feel lucky they still have jobs.  They should want to stay and help revive their own reputations.  Who would or should hire people that did what they did to that company.  I think that is some of the feelings going around the hill.   Sort of what is the next shoe to drop, what are we going to be surprised by tomorrow.   I think they have had it up there in dealing with these kinds of issues …finding out about them after the fact.  I have seen Senator Grassley several times take on an issue such as this one when he feels someone or some group is stonewalling him on information.  But when he gets the information and understands that the taxpayers are getting the best they can for whatever the issue is then you will see that they will someone that will work with them.  It’s a matter I think of being blindsided and frustrated so yes maybe Congress does deserve some of the blame.  But when they are asked to do what they are doing they do have a right to know all the facts and when they are not given them they react the way they are.  Their phones are ringing off the hook from their constituents yelling at them for what the government is doing by propping up these failed companies with their tax dollars.  Many of them don’t feel its right.  So they are squeezed the whole issue. 

So yes maybe they are wrong for saying all that and reacting the way they do, but much of that could have been dealt with had they not been blindsided by issues like this.  There are 500+ members that feel they voted and did the right thing without knowing they were approving issues like this.   And know its coming back to bite them in the butt too.

Ed  [Redfern, Washington DC]

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I read with great interest, Warren.
And I understand the outrage at the, well, outrage. Politicians love their TV time and soapboxes. And America reacts tot he transparency of big payouts, something you and I knew but that, in our transparent culture, is coming to light for many more for whom the dollar figures seem extraordinary.
But I keep coming back to this:  if the US taxpayer is paying, bailing out, contributing, then we get a say in how and why the money is spent and accounted for…I am not seeing that accountability. The CEO of Fannie Mae waves his huge salary for a year (probably not going to change his lifestyle. And considering the robber baron CEO who came before him, the decimation of their business, and the struggles of their current and laid off employees, the big wigs taking a hit seems fair to me). But then four others get 1/2 million dollar bonuses.  Now? 
These stories are so rampant, the big paydays are still coming for some, and the US taxpayer is paying for it and thus taking the hit.
I understand the demagoguery that’s happening and question that, of course. But I don’t think it’s just the optics that seems off about what’s going on behind the scenes.
On another note, hope you are well!

David [Singleton, Washington DC]

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Hi Warren,
Welcome home.

I agree with you on this, even though I am a member of the proletariat. Although I’m not sure that they were all retention bonuses. I read somewhere recently that up to half went to people who have already left AIG, and many of these people are non-US citizens who live, consume and invest abroad. That doesn’t smell right, in my opinion.

All best,

Ken [Weisbrode, Florence, Italy]

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Thanks, Warren.  I love all of this talk about government taxing the bonuses away.  First, not being a tax lawyer, I question Government’s ability to impose a tax on money that has already been earned and paid (which would make it a wealth tax, as opposed to an income tax).  Second, I question whether the targeting of such a specific group of individuals with a law (when they have broken no existing law) is not a Bill of Attainder (an area of Constitutional law with which I admittedly know little, but the idea is that the Government can not target specific individuals with its laws).
The most depressing trend in all of this had been the willingness on the part of Obama and the vast majority of the Congress to disregard legal boundaries such as the idea that contractual rights should not be cavalierly thrown aside because they yield a distasteful result.  This trend is also seen in the idea that bankruptcy judges should be given a power to alter mortgages that were not made with the understanding that their terms could be unilaterally altered by a judge (which would have affected the calculus of those making the loans).  This reminds me of the story of Argentina which, around the turn of the last century, was recognized as one of the most potentially economically potent countries in the world but pissed it away through populism (in a parallel to our circumstances, Juan Peron actually alleviated economic problems at one point by prohibiting evictions).  Mitt Romney said that he feared this country would become the "France of the 21st Century."  I am worried that, if we don’t watch our step and get back to disciplined respect for property, we will become the Argentina of the 21st century.
Later- Jim [Colt, Washington DC]

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I agree.  A knee jerk political response to a case of business judgment.   Retention is a legitimate risk as an ongoing concern.  No on going concern means the fed loans default.
I’m not sure why we thought the political DC and NY States Attorney would act any differently.  The dog spots are still in the same place.
Dan [Mariottini, Washington DC]

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Warren,

Can employees quit after receiving retention bonuses? If so, they are not retention bonuses.

Regarding the rule of law: When Condi Rice ordered Stanford Social Science dean John Shoven to cut a department; he arbitrarily cut the Food Research Institute. I asked the new dean, Wally Falcon, how Stanford could do that inasmuch as the Institute was established with Herbert Hoover’s money for a specific contractual purpose. "We have our lawyers," he said!    

I’m sure there is a way to abrogate AIG contracts if the government really wants to. How about a retention-bonus tax to be applied when the employees don’t have to stay, have "defrauded the public," or a tax on "excess" bonuses for bailed out executives. I know this is a slippery slope, but I though we would see more creativity out of government lawyers.

You are hoping that Obama will come to his senses? These are his senses!

Best,

Jim [Roumasset, Hawaii]

P.S. Do you think Larry Summers has lost a step or two? He used to be more articulate. Maybe getting beat up by Harvard women cost him. "Names will never hurt me," indeed!

*******************************

Nice to hear from you. I have a somewhat different view on the government’s actions.

First, it is very much the pot calling the kettle black for members of Congress and the president to criticize the financial practices, compensation, and perks of the financial companies when they can’t control their own government’s ridiculous spending, debt, and complete failure to properly handle the idiot beggars at its door.

They dare to propose suing companies as shareholders when they sit there with sovereign immunity as they attempt to impose slavery through the financial practices of the government and Federal Reserve. And then they dare to use force (taxation) to steal what they failed to properly supervise through their police power when they made those ridiculous bailout packages initially.

As I mentioned elsewhere previously, I don’t think there should have been any bailouts, stimulus, or anything else. Those banks, however large, should have been allowed to crumble like the World Trade Centers by their own ignorance instead of at the hand of terrorists.

The banks had no business financing all that crap, and without government assistance they would have probably renegotiated the mortgage loans on their own or otherwise tried to either salvage the business or cut loose the losses by simply forgiving loans and issuing 1099s for debt forgiveness, in which case the owner of the home would have a house to protect, would owe taxes to the government on the debt forgiveness, and the shareholders in the banks could sue the directors if they so choose, as it is their responsibility to look after the managers of their company, and unlike voters, they are voluntary participants in the ‘company.’

Now, instead, the government has ‘extended a helping hand’ by destroying the government’s financial credibility (as no reasonable person could expect the debt to be repaid, which means the fuse is lit for a complete meltdown).. Banks that were deceptive and greedy in their loan practices, leading along simpler people without the sophistication to understand monetary policy.. Weakened by the crisis, the government is breathing new life into bullies so that they can continue to financially abuse people while driving up the federal debt on which people also pay taxes. I don’t think the crisis is over. I think it has just begun.

I think the next great act of terrorism is going to come from militias in the United States, not from Muslims, who, of course, were not so greatly affected by the financial ‘crisis.’ When the Muslims hit, they killed their victims. Others were merely angry observers. What the financial community, government, and fed have done has inflicted great injury while leaving the victims alive, hurt, scared, and of course angry, often with little or nothing to lose. Good luck making peace with that group before they take out Washington once and for all.

Congratulations, Wall Street and Washington! You have worked a miracle! You have given radical Muslims and the extremist right-wing neo-Nazis a reason to work together to blow Washington D.C. off the map!

David [Garland, Richmond VA]

**********************************

[1] Matt Taibbi, "The Big Takeover" Rollingstone.com March 19, 2009

[2] Michael D. Shear and Paul Kane, "Obama Looks for Calm in a Firestorm" The Washington Post, March 22, 2009, Page A10

The issue of bonuses is complex. In some societies, Christmas (or year end) bonuses are a traditional way of sharing the risk of how well a firm does each year between firms and their employees. In poor years, employees share the firm’s fate by taking home less (no bonus or a smaller bonus). The signing bonus in sports increases a star athlete’s salary above and often millions of dollars above his or her fellow athletes. In the case of sports we all recognize that the club owners pay such big bucks out of the desire to maximize the income of the club for their own benefit. Generally we cheered the lucky athletes for their great skills and for getting some of that money for themselves (earlier rules in base ball, for example, imposed monopoly like restrictions on recruiting that kept more of the clubs’ incomes for the owners and less for the players).

Companies have also increasingly fashioned stock options and other bonus incentives (partially influence by tax laws) as a tool for rewarding above average performance and increasing the firm’s profits. For senior management (and financial market traders) performance bonuses were some time VERY large. Many shareholders (and society at large) are increasingly questioning whether bonuses as structure today do in fact increase shareholder value. The practice needs and will get a serious review by shareholders.

Weaknesses in corporate governance may make it difficult for shareholders to properly monitory or control the salaries and bonuses senior management give themselves. If performance bonuses are a reward for improving the firm’s profits, something has gone wrong if bonuses were paid in 2008 when many firms made losses. The structure of bonuses in many firms, especially financial firms, reward very short term profits (making loans) without sufficient regard for the longer run impact(loan repayment) of investments made today. Thus long run profits were sometime sacrificed for very short run gains. It is fair to say that in many instances the bonus system is broken and needs to be fixed.

The outcry over AIG $165 million in bonuses paid this week, on the other hands, seems largely misplaced. First of all they are not performance bonuses. They are retention bonuses—bonuses paid to keep valuable knowledge employees from leaving a sinking ship. Chief Executive Edward Liddy, appointed by the government in September 2008 as part of the government’s infusion of $173 billion, “said he knew about the bonuses since October but determined that they could not be legally altered. He also said he believed the retention bonuses at the financial products unit were necessary, so that competition would not take AIG’s best minds away…. I am trying desperately to prevent an uncontrolled collapse of that business,” he said. “This is the only way to improve AIG’s ability to pay taxpayers back quickly and completely and the only way to avoid a systemic shock to the economy that the U.S. government help was meant to relieve.”[1] Losing the staff with the inside knowledge to unwind AIG’s credit default swaps and other complex instruments could cost the tax payers a lot more than the bonuses for keeping them.

From here the story gets totally bazaar and ugly. The fact that the government had put tax payer money into AIG gave the government a responsibility to ensure that those funds were used as intended in the public interest. But Congress’s reaction to the bonuses demonstrated some of my worst fears of the likely consequence of government involvement in “private’ enterprises. Congressional rantings befitted a ship of fools. No one can deny that many businesses (and investors) have made foolish and costly mistakes. At least in the beginning they thought they were doing so with their own money, which sharpens the mind. AIG’s bonuses may or may not have been good business decisions (saving the taxpayers money), but it is laughable to think that Congress can make wiser ones. What are we to think of Congressman Barney Frank’s complaint that: "These are not the people you want to retain — you need to get people who understand the mistakes and undo them,"[2]

The Federal Reserve (which provided the initial $80 billion bailout money last September) approved the bonuses last fall. Pointing figures at who knew what, when only undermines the credibility of Congress and the Administration and is irrelevant. Fannie Mae, which is now fully owned by the government, is paying four top executives retention bonuses of over one million dollars each. In this instance, at least, the government (FHFA) considers the bonuses a sound business decision.[3] One of the most ludicrous rants from Congress, and there are many to choice from, came from Congressman Paul Kanjorski, D-Pa "Why wasn’t this committee informed? And do you realize that the actions that you take at AIG and took in this precise case not only impacts AIG … but it may have jeopardized our ability to get a majority of this Congress to support further legislation to provide funds to prevent a recession, depression or meltdown?" It is hard to believe that these are the words of an adult.

Congress’s and the Administration’s demands that the AIG bonuses be stopped, and then after they had been paid that they be returned, ran into the constraint that these are valid contracts made with people who had other options and that we still believe (most of us anyway) in the rule of law. Such contracts can be abrogated or renegotiated in the contact of bankruptcy but AIG is not operating under bankruptcy rules. Congress’s rantings can be dismissed as the political posturing that it is. After all few of us are happy about out of control bonuses that don’t really always seem to be serving the interests of (long run) shareholder value. But the efforts today to pass tax legislation to tax back most of AIG’s bonuses reveals a big brother mentality that is truly scary. Sadly President Obama has joined in the demagoguery. The government has already increasingly intruded into the internal affairs of a growing list of company. “Late last week, Kovacevich gave a talk at Stanford University, complaining about how unfair it is that the government forced his bank to take $25 billion in bailout money last year when it could have easily raised private capital — and then compounded that outrage by changing the terms of the deal and forcing Wells to cut its dividend.”[4]

In my opinion the financial sector crisis is being resolved and is about over as a result of actions taken by the Federal Reserve. The sight of a hysterical and vindictive government willing and able to bully the financial industry and potentially any other area of the economy is dangerous and threatens to derail or at least delay the market’s return to health. Investors will be more reluctant to restart investing and lending under these conditions and the economy cannot recover until they do. I hope that President Obama comes to his senses soon.

[1] By David Goldman and Jennifer Liberto, "Tug of War over AIG Bonuses" CNN Money.com, March 18, 2009

[2] Ibid.

[3] Zachary A. Goldfarb, "Fannie Plans Retention Bonuses as outlined by the Government", The Washington Post, March 19, 2009, Page D01.

[4] Steven Pearlstein, "Wall Street’s Dangerous Refusal to Learn", The Washington Post, March 18, 2009, Page D01.

The Weekly Standard March 9, 2009

www.weeklystandard.com/Content/Protected/Articles/000/000/016/206tjbiw.asp

Cash for Balkans
A sound currency is the least of Bosnia’s problems.
by Stephen Schwartz
03/09/2009, Volume 014, Issue 24

One Currency for Bosnia
Creating the Central Bank of Bosnia and Herzegovina
by Warren Coats
Jameson, 349 pp., $42.50

Thirteen years after the Dayton peace accords that ended the combat in Bosnia-Herzegovina, and almost a decade since the end of the NATO intervention in Kosovo, these two Balkan examples of American-supported "nation-building" seem about to reappear on the political horizon. And Clinton-era figures now prominent in the Obama administration–Joseph Biden, Hillary Clinton, Richard Holbrooke–are all apt to preen about their exploits in Southeast European conflicts. So with the reappearance of Americans associated with the Balkan torment as policy wizards, it makes sense to examine what has transpired in Bosnia and Kosovo since the onset of Western involvement.

Warren Coats, who had 26 years’ service as an economist for the International Monetary Fund, has published this densely detailed but instructive account of how, with his participation from 1996 to 1999, divided Bosnia was provided with a modern financial system by the international community that had assumed responsibility for that badly wounded country’s future.

Textbooks and similar authoritative chronicles of the practical transformation of onetime Communist economies, deformed or disfigured by years of ideological interference, are rare. Coats brought to his work in Bosnia a background that included experience in Bulgaria and Moldova–two deeply corrupt states that, although they did not suffer the bloodshed seen in Bosnia, were (and remain) economically and socially handicapped–as well as in the Palestinian territories. He later worked in Kosovo, Serbia, and Turkey.

He patiently recounts the travails required for the confection of a hard currency, the Bosnian convertible mark or KM. It replaced the Deutsche Mark, which was used as Bosnian money immediately after Dayton, and at the end of 2001 gave way in Germany to the euro. This is an irreplaceable contribution to the study of post-Communist finance.

Coats and an army of international advisers and mentors, including personnel from the Agency for International Development, had to contend with many obstacles in the creation of a Bosnian currency, a policy objective mandated by the Dayton agreement. Serbs, now as then, occupy more than half of Bosnian territory as a statelet that was the model for Moscow’s puppet regimes in Abkhazia and South Ossetia. Croat representatives had their own claims on turf and practice. Bosnian Muslim representatives, like their ethnic peers, were encumbered by a socialist centralized "payment bureau" system that substituted for normal banking.

As Coats describes it, the domestic payment law in the Muslim-Croat federation making up the rest of Bosnia "was confusing, internally inconsistent, and at variance with actual practice." The payment bureau acted as an intermediary between financial clients and the banks. The international advisers did not consider the payment bureau to be a holder of deposit liabilities, but the functionaries of the Federation Payment Bureau viewed their outfit as a central bank.

Transferring the daily cash operations required by Bosnian businesses from the payment bureau to a brand-new Central Bank of Bosnia-Herzegovina–intended to function at an international standard and succeeding the former National Bank of Bosnia-Herzegovina–had to be accomplished without the new institution enjoying credit resources to cover overdrafts.

Such issues are as daunting for the lay reader as they were (in Coats’s narrative) for him and his colleagues. Coats acknowledges the useful counsel of Steve Hanke, the libertarian economist, who noted that a "currency board" crafted for Bosnia by the international community, which should have kept a strong hand on financial operations, included too many loopholes that prevented it from promoting monetary stability. Nevertheless, overcoming limitless barriers, Coats and his team succeeded in establishing the KM as a solid currency, with "culturally neutral" paper money designed to be acceptable among Serbs, Croats, and Bosnian Muslims. Coats describes the introduction of the KM as "an enormous success," but Bosnia’s financial restructuring failed to solve serious problems of lawlessness.

He describes as "depressing" the spectacle of Bosnian political obstruction of privatization of state banks and other financial reforms. In addition, because of persistent ethnic rivalries and the hoarding of KM coins, the definitive acceptance of the KM as Bosnia’s money was held up for years.

Unfortunately, such minor issues as the scarcity of paper and small metal change don’t figure in a study written from the viewpoint of an "international," as foreign administrators are known in the Balkans. But this is predictable:

Coats shuttled in and out of Sarajevo without having to deal with the frustrations of daily economic life in a deeply traumatized, ex-Communist country. Until recently, the worst thing anybody living in Bosnia could do was to offer a bill over 10 KM as payment for any item: Ne imam sitni (I don’t have change) was the infuriating response of Bosnian service and clerical employees to any such tender. Under the payment bureau system, merchants were required to settle their accounts daily, and this was a pretext for starting business each morning without the small "bank" used to make change in any normal store. Some Bosnian retail clerks were so primitive in their outlook that they would not accept bills that had slight tears in them!

Bosnia was lucky that dedicated professionals like Coats came and fought their way through thickets of intrigue and obstinacy to create a central bank. Nobody sane, in a country undergoing nation-building, would reject such a glittering asset, and Coats rightly expresses satisfaction that Bosnia was the first ex-Yugoslav republic to replace the old central payment bureau system–although it embarked on the path to modern banking later than others. But now that the "Bosnia crowd" are restored to power in Washington, should we ask how such efforts have improved the lives of Bosnians?

As a consequence of the neglect of Bosnia’s social rehabilitation, the country has become a field for the expansion of radical Islam. When Dayton was signed–imposing what increasingly looks like a permanent partition–"Afghan Arabs" who had gone to the country to pursue extremist jihad were only a minor element: Some 6,000 of them, at most, joined the Bosnian struggle, but comprised no more than a rivulet in the wide stream of armed Bosnian resistance. These mujahedeen won no battles and otherwise never influenced the outcome of the fighting, and their Saudi-sponsored Muslim missionary work was met with hostility by indigenous Muslims dedicated to moderate Sunnism.

Today, however, after so many years of endemic unemployment, and with the growth of a Muslim mafia, Bosnian Muslims find their capacity to resist extremist blandishments seriously weakened. The country’s top Islamic cleric, Mustafa Ceric, has revealed an almost limitless capacity for self-aggrandizement. Parading in white robes with gold brocade trim, Ceric travels around Europe and visits the United States (where he formerly acted as an imam in Chicago) projecting himself as a candidate for an Islamic papacy, and delivering speeches, empty of serious content, on interfaith cooperation.

As 2008 wound down, Ceric generated a new, bitter controversy with a plan to erect a massive residence for himself on a hill overlooking Sarajevo. The Bosnian poet Semezdin Mehmedinovic accused Ceric of paying for his new palace with money from Bosnian Muslim and ethnic Albanian gangsters. Ceric’s building project has also elicited protests by students at the Sarajevo Faculty of Islamic Studies (who lack a dormitory) and condemnation from less prominent, but more respected, clerics. The latter include Mustafa Spahic, preacher at the Cobanija mosque, and his colleague as a professor of Islamic studies, Resid Hafizovic, one of the world’s outstanding scholars of Sufism.

Asked about the spread of Wahhabism in the country, Hafizovic has warned pointedly against "the uncontrolled operation of an unacceptably large number of madrassas and Islamic universities .  .  . [a] threat and betrayal of quality in the educational institutions of the Islamic community."

Notwithstanding an excess of Islamic schools, Hafizovic continues, "we see the paradox that Bosnian Muslims, instead of being freer in spiritual terms, more creative, self-confident, and intellectual, today find themselves in a condition of utter spiritual enslavement, crippled, and intellectually castrated."

Coats’s account of Bosnian economic reform shows the bright side of nation-building. But those who have seen the realities of Bosnia in the streets of Sarajevo must conclude that something more than foreign generosity and expertise is required to rescue countries from dictatorship and war.

Stephen Schwartz is the author, most recently, of The Other Islam: Sufism and the Road to Global Harmony.