Is There Inflation Ahead?

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 25th 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 19th 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.

[1] This is a simplification of the following ΔP/P = ΔM/M – Δk/k – Δq/q, more correctly reflects the percentage rate of change of each variable.


[2] Richard W. Fisher (President of the Federal Reserve Bank of Dallas), "Storms on the Horizon",  Remarks before the Commonwealth Club of California, San Francisco, California,  May 28, 2008.

What are SDRs?

The very large increase in world trade (globalization) over the last four decades has enormously reduced poverty and raised living standards for very large numbers of people. Government policies in the U.S., China and elsewhere have produced large, unsustainable trade imbalances (mismatch of imports and exports). Free trade on its own would not produces such imbalances.  New Global Studies has just published my article “Time for a New Global Currency?” The article explains what the IMF’s Special Drawing Rights (SDRs) are following the G 20s recommendation that the IMF allocate an additional 250 billion dollars worth of them, and how they might facilitate achieving and maintaining better global balance.

Time for a New Global Currency?



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.


Friday, April 03, 2009


Currency amount under Rule O-1

Exchange rate 1

U.S. dollar equivalent

Percent change in exchange rate against U.S. dollar from previous calculation






Japanese yen





Pound sterling





U.S. dollar







U.S.$1.00 = SDR

0.666621 2

-0.233 3

SDR1 = US$

1.50010 4






The exchange rate for the Japanese yen is expressed in terms of currency units per U.S. dollar; other rates are expressed as U.S. dollars per currency unit.



IMF Rule O-2(a) defines the value of the U.S. dollar in terms of the SDR as the reciprocal of the sum of the equivalents in U.S. dollars of the amounts of the currencies in the SDR basket, rounded to six significant digits. Each U.S. dollar equivalent is calculated on the basis of the middle rate between the buying and selling exchange rates at noon in the London market. If the exchange rate for any currency cannot be obtained from the London Market, the rate shall be the middle rate between the buying and selling exchange rates at noon in the New York market or, if not available there, the rate shall be determined on the basis of euro reference rates published by the European Central Bank.



Percent change in value of one U.S. dollar in terms of SDRs from previous calculation.



The reciprocal of the value of the U.S dollar in terms of the SDR, rounded to six significant digits.


Prepared by the IMF Finance Department



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.




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.



[1] I was Chief of the SDR division of the Finance Department of the IMF from 1982 – 1986.

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

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

[4] The SDR interest rate is also determined daily on the basis of three month government securities with the same weights as the currency basket.

[5] Each new allocation is added to all previous ones and the total is called the “net cumulative allocation.”

[6] I have often wondered whether those politicians demanding an appreciation of the Renminbi realized that it would raise interest rates in the U.S. when the Peoples Bank no longer had such large foreign exchange reserves to invest in the U.S..

[7] This describes a relative imbalance rather than a global shortage of reserves. If as now the world were in recession or suffering a global shortage of reserves (which would otherwise require a global deflation to overcome) the IMF’s members could authorize a further allocation of SDRs as the G20 has just recommended.

[8] The SDR’s value could also be fixed to gold, as it was initially, or to baskets of commodities or goods and services. See Coats, 1994.

[9] Coats, 1990.

[10] Coats, Gons, Leddy, and van den Boogaerde, 1987.

Relaxing Bank Accounting Standards—A Big Mistake

“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.

More on AIG bonuses

Hi all,

As usual, many of you had interesting comments on my March 19th 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,



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]


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]


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]


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]


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]


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]



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!


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" 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

AIG Bonuses

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, 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.

A review of my book, “One Currency for Bosnia”

The Weekly Standard March 9, 2009

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.

The Financial Crisis: Act II

A combination of factors are producing huge loses to mortgage lenders that threatened the collapse of a large share of the financial sector. The Main Street consequences could have rivaled the Great Depression. Governments around the world intervened dramatically to save their banking systems with deposit and lending guarantees and the injection of tax payer funds to bolster banks’ capital in an effort to prevent the abrupt and damaging curtailment of normal bank lending. While these unusual steps may have been necessary to avoid still more catastrophic losses to Main Street, they carry significant risks of their own if not carefully designed to minimize moral hazard and explicitly limited in duration. While a collapse of the financial sector would dramatically worsen the recession that the U.S. and Europe are now in, the recession itself makes it more difficult to stabilize financial sectors. None the less, monetary and fiscal measures to moderate the severity and duration of the recession should not prevent macroeconomic adjustments and the healthy shakeout of inefficient firms that the economy needs.


Act I – How We Got Here

Scene 1 – The Housing Bubble Inflates, Then Deflates

Government policies to promote home ownership pressured lenders to lower underwriting standards and increase lending to previously unqualified borrowers. An abundance of world saving and easy monetary policy and the mortgage guarantees from Fanny Mae and Freddie Mac (government sponsored enterprises mandated with attracting funds to mortgage lending) channeled large amounts of low cost funds to home buyers. These factors along with poorly designed land use planning restrictions in some areas increased demand for housing more than supply and prices rose rapidly. The securitization and pooling of mortgages into Mortgage Banked Securities (MBSs) lowered the cost and spread the risk of mortgage lending world wide but also weakened the financial incentives of agents to monitor compliance with already low underwriting standards. With the repeal of the Glass Steagall Act in 1999, which separated investment from commercial banking, the short-term “performance” bonus practices and very high leverage (investing borrowed money) of many investment banks began to dominate the more conservative culture of commercial banks further eroding mortgage underwriting standards to levels no one believed could service beyond a few years (before which bonuses would already have been collected).[1] Thus principle/agent weaknesses were greatly exacerbated. Irrational expectations of ever increasing housing prices attracted speculators on the investment side as well. Overly complex mortgage backed securities over relied on credit rating agencies with no experience with such instruments and conflicts of interest. Gaps in supervisory coverage between the Office of the Comptroller of the Currency (OCC), which supervises all National Banks, and the Federal Reserve, which supervises bank holding companies (among other financial entities), left excessive risk taking unsupervised. The widely held assumption that the government would back up the commitments of Fanny and Freddie, meant that private speculators could take their winnings and the tax payers the losses. Players in the mortgage markets may have acted recklessly but generally they were acting rationally within the policy/regulatory framework the government provided. Wide spread fraud (misrepresenting borrower qualifications), encouraged by the short-termism of investment banking also played a role.

Housing prices couldn’t and didn’t go on increasing at such rates. Demand slowed at such prices. Supply caught up and exceeded demand; the stock of unsold houses rose and the bubble burst. Borrower defaults began to rise above usual rates. The market value of MBSs fell and uncertainty over how much defaults would increase made it difficult to trade them even at steep discounts. By 2007 Wall Street began to realize that banks and other investors were going to absorb hug losses but the complexity and opacity of the structured financial instruments by which mortgages had been distributed made it difficult to evaluate who ultimately would pay them. These developments along with tightening monetary policy (rising interest rates) led the entire financial system to demand more liquidity to compensate for the reduced liquidity of MBSs and a loss of confidence in financial market counterparties. In mid 2007 hedge funds and other Wall Street firms began gradually to deleverage (reduce their reliance on borrowed funds to supplement investors’ funds and to fund investment banks, insurance companies and others). The cost of unsecured interbank lending sky rocketed. The TED spread (difference between the three month London Interbank Offer Rate—LIBOR—and the three month U.S. treasury bill rate) jumped from its usual 0.1% or so to over 4%. Hedge funds and others began to reduce their reliance of borrowed funds (deleveraging).[2]

Housing price bubbles and their collapse even larger than in the U.S. are being experienced in many countries. The UK and Spain are particularly hard hit. These also reflect the world wide glut of saving and very low real interest rates over much of the last quarter century and especially 2002-3. Some of America’s mortgage losses are also being absorbed abroad because of foreign investments in U.S. MBSs.


Scene 2 – Federal Reserve Responds to Liquidity Demand

Whether to correct for the overly lax lending standards of previous years or because of the hording of liquidity by banks concerned by the loss of their normal sources of liquidity (or both), lending standards tightened. The Federal Reserve and the central banks of other affected economies responded in traditional fashion to provide the increased liquidity banks demanded in order to keep interest rates from rising and the money supply and credit growth from collapsing. The Federal Reserve responded quickly to supply the increased liquidity demanded by the market and even introduced new facilities that extended the terms, increased the list of eligible collateral (Federal Reserve Bank loans are collateralized), and broadened the range of institutions that could access these new facilities. Lenders were also encouraged to renegotiate the terms of nonperforming mortgages if foreclosure could be avoided and the lender’s losses reduced.[3]

Central banks traditionally intervene to provide solvent banks with liquidity when depositors suddenly withdraw funds or secondary markets for bank assets become disorderly. Federal Reserve provision of liquidity to the market takes broadly two forms: collateralized lending to banks and purchases of assets from the market. Collateralized lending does not spare banks losses on their loans or the assets they invested in. The Federal Reserve would absorb losses from “toxic” collateral only if the banks it lends to fail. So called “open market operations” in which the Fed buys securities outright are a different matter. Hence such operations are generally limited to the highest quality assets—generally government securities. The Fed now accepts MBS as collateral in some of its lending facilities but does not buy them in open market operations.[4] More recently it has taken the extraordinary step of buying corporate “commercial paper” in the open market because of the sudden difficultly companies have been having financing their operations in this customary way. In part, this reflects the fact that banks are no longer the dominant source of funds to the economy.

At the same time the Federal Reserve is lending huge amounts to banks and others on Wall Street, it has also been selling (previously purchased) government securities from its portfolio and attracting (now) interest baring deposits from banks in order to keep the federal funds rate at or near its policy target rate. At first glance this two way activity seems hard to understand but a closer look at the deleveraging process makes clear that the Federal Reserve is facilitating the markets rapid shift toward safety. If investors in hedge funds or money market funds (already relatively safe) withdraw funds in order to reduce the riskiness of their investments two questions arise: a) where will the funds get the money to pay for these withdrawals and b) where will the investors put the money they have withdrawn.

With regard to the first question, if funds try to borrow the money needed to repay investors, the leverage of the funds would increase. A larger share of the assets in the fund would be financed with borrowed money rather than with the deposits of investors. But leverage is now more expensive and harder to get. Thus funds will be forced to, or will chose to, sell assets in order to raise the money needed for the investor withdrawals. These sales add to downward pressure on the market price for these assets (every thing from GM stock to subprime MBSs) which might add to the demand by investors to withdraw their funds. Some of the stock markets incredible volatility probably comes from such forced sales. Furthermore, the market’s reduced preference for risk implies higher risk premiums for assets with unchanged expected returns. The fall in the market value of MBSs, for example, even without further deteriorations in their expected performance, reduces banks’ capital. Thus increased demand for liquidity (and safety) and bank capital are interrelated. Banks can use these assets as collateral to borrow the funds needed from the Federal Reserve to cover withdrawal, but this slows the pace of deleveraging.

With regard to what investors do with the money they have withdrawn, they will desire to invest it in something safer. The safest investment is in government securities and the yields on these have been driven to very low levels as the market has moved to safety. The Federal Reserve’s sales of government securities to keep their interest rates from falling too low is in effect helping the market shift from riskier investments to safer ones.

Banks, and “Wall Street” more broadly, received such special treatment because of their special character. Wall Street refers to so called “financial intermediaries” (banks, insurance companies, mutual funds, etc.), which facilitate and intermediate the flow of saving from households and firms to Main Street (manufacturing, agro, and service firms and households), which use these funds for investment and to smooth the uncoordinated flow of income and expenditures. Such market allocation of lendable funds has proven dramatically more efficient in directing them to more productive uses than the centrally controlled allocation of “planned” economies. Our higher standard of living reflects our more productive allocation and use of resources (for investment in physical and human capital). Secondary markets in which financial assets (stocks, bonds and now bank loans) can be traded have increased the “liquidity” of these assets and thus lowered the cost of financial intermediation by reducing the amount of cash banks and other Wall Street firms must keep on hand to bridge the mismatch of receipts and payments. Successful market allocation of resources depends critically on the incentives and discipline of profit and loss. Those taking risks in search of profits must act in the knowledge that they will pay the price of mistakes or bad luck. In addition, banks provide the payment services our modern economy critically depends on.

The American banking system is generally strong and sound because the profit and loss discipline of the market eliminates poorly run ones. Banks limit the risks they take with depositor and shareholder money because they do not expect the government to bail them out of their mistakes. This expectation reflects the willingness of banking supervisors to close insolvent banks. Closing a failing bank, rather than bailing it out, can be risky because of its potential spill over to other sound banks and the risk of wide spread deposit withdraws by depositors fearing the loss of their money, so called “bank runs”. But the U.S. has effective bank bankruptcy laws and tools, which largely overcome these risks. Thousands of banks have been taken over by the Federal Deposit Insurance Corporation (FDIC) and resolved (sold in whole or in pieces, or otherwise liquidated) without significant disruptions to the banking system. These laws give regulators powerful tools (basically the power to nationalize undercapitalized banks and to sell them in whole or in part and liquidate whatever is left) but limit their discretion in how these tools are used by the requirement that critically under capitalized banks must be taken away from their owners and resolved with the least cost to the insurance fund (FDIC) and other depositors.

These tools were applied to the growing but modest number of banks that failed over the past year (Countrywide, IndyMac, Washington Mutual, and Wachovia to name the bigger ones). These resolutions were handled smoothly with no disruption to the market. However, mortgage and related losses also fell heavily on investment banks and even insurance companies.[5] When a few of them began to fail, the legal provisions for bank failures were not available. Thus the arranged buyout of Bear Stearns, an investment bank, earlier this year required the approval of its shareholder who demanded a somewhat higher prices than originally offered and the buyer (JPMorgan Chase) demanded and received from the Federal Reserve a guaranteed limit on its potential losses on Bears Stearns mortgage related assets. While the resolution of Bear Stearns was probably the best that could be achieved with the legal tools available and looked much like an FDIC resolution other than the modest price paid to shareholders, it was not guided by explicit legal rules. The later quasi (re)nationalization of Fannie Mae and Freddie Mac moved closer to the approach of an FDIC resolution but again without the same legal tools. These two Government Sponsored Enterprises (GSEs) where put into Chapter 11 bankruptcy, under the supervision of the newly created Federal Housing Finance Agency (FHFA) and with new managements and boards. However, all creditors were reassumed by the Treasury’s commitment of an unlimited line of credit and up to $100 billion capital if and as needed by each of the two. Shareholders on the other hand were deprived of any dividends and the prospect of surrendering their shares if Treasury capital was needed. On November 14 Freddie Mac reported $25 billion in losses for the third quarter, which activated the first of the promised tax payer capital injections of $13.8 billion to avoid insolvency. The future resolution (downsizing and reprivatization or orderly liquidation) of these two GSEs will be decided by the next congress. They should be liquidated.

As estimates of potential mortgage losses continued to rise,[6] the viability of additional banks came into question. Lehman Brothers and Merrill Lynch (both investment banks) entered into discussions with potential buyers. When Dick Fuld, CEO of Lehman Brothers, refused the buyout offer from Barclays, the Federal Reserve refused to sweeten the deal with guarantees and allowed Lehman Brothers to enter Chapter XI bankruptcy, while Merrill Lynch accepted the buy out offer from Bank of America. America’s remaining two large investment banks, Goldman Sachs and Morgan Stanley, promptly requested and were granted permission to convert to commercial banks, thereby gaining access to Federal Reserve credit facilities in exchange for the significantly tighter regulation of commercial banks.


Act II – Financial Panic and Beyond

Scene 1—Addressing the Panic

The September 15th bankruptcy of Lehman Brothers, the sort of market discipline of excessive risk taking and failed gambles that I favor, triggered a genuine financial market panic. The TED spread rocketed from around 1.0% the first half of September to around 4.5% by early October.[7] Treasury Secretary Paulson rushed to Congress with a two page proposal to authorize the Treasury to buy up to $700 billion of MBS “from any financial institution having its headquarters in the United States”[8] under terms and conditions to be determined by the Treasury. Initially his proposal was to buy MBSs from banks under rules to be determined. After a false start in which the House rejected the proposal, the Emergency Economic Stabilization Act of 2008 was passed and signed into law on Oct 3rd, 2008. In what is now a 451 page law, which included a number of other unrelated or tangentially related measures, the Act essentially authorizes the Treasury to borrow up to $700 billion in order to aid the financial sector in almost any way it decided would help restore normal bank lending. As evidence mounted that lack of capital rather than liquidity was the primary cause of the claimed freeze up of bank lending[9] and that it would be almost impossible for the Treasury to determine appropriate prices at which to buy “toxic” MBSs, the Treasury shifted the primary use of this authority to recapitalizing under capitalized but sound banks. The Act also more than doubled to level of deposit insurance coverage from $100,000 to $250,000.

On October 8, UK Prime Minister Gordon Brown announced that the British Treasury would inject capital (buy shares) in eight major British banks and guarantee interbank loans, the Bank of England would double the size of its “special liquidity scheme,” and the government would increase the size of guaranteed deposits.[10] On October 13 most European government promised to follow suit. These measures taken together were meant to stop bank runs, increase bank capital, and remove the counterparty risk of interbank lending in order to restore normal lending and credit flows.

In addition, the Federal Reserve has taken unprecedented measures to unblock normal credit flows to Main Street firms and household outside of the traditional commercial bank channels, which have become less important in recent years. Following panic public withdraws (“runs’) on money market mutual funds, the government guaranteed their principle. Not only did most such funds stop purchasing most commercial paper, a very important source of trade and industry finance, but they were forced to sell some of the paper they already held to finance depositor withdrawals. The Federal Reserve then introduced an off balance sheet facility for buying commercial paper directly.

These were aggressive interventions into financial markets, which were bound to interfere with normal market discipline of the behavior of its participants. Were they justified? Can they be designed to minimize the moral hazard of encouraging risky behavior by bailing out mistakes? And why bail out Wall Street rather than Main Street?

Why Wall Street rather than Main Street is easy. Wall Street is “merely” the intermediary between savers and investors, between household/firm providers of funds and the Main Street users of these funds. The collapse of Wall Street would seriously impair or even bankrupt quite innocent Main Street firms or households by cutting off the credit they depend on for investment and day to day operations through no fault of their own. Saving Wall Street from collapse potentially saves the entire economy from unnecessary collapse. But were such sweeping interventions necessary to prevent the collapse of Wall Street and restore normal bank lending? That is hard to say for sure, but the risk of misjudgment was too great to take. Given the information in hand, governments were probably justified in taking these measures.


Scene 2 – Bailout Risks

Stopping the financial panic required steps to reassure depositors and investors that it was safe to leave or put their funds in banks and to increase bank capital to levels that would allow them to continue lending to credit worthy customers. Uncertainty about the soundness of banks needed to be removed. It was too late for carefully considered and finely tuned measures, thus broad brushed guarantees and capital injections were used. None the less, the cost to tax payers should be considered and damage to market discipline should be minimized where possible. The rules governing which financial institutions get tax payer funds to bolster their capital and the terms and conditions attached to such funds (e.g. matching private sector capital injections, cost to existing shareholders, tax payers’ share in upside profits, and duration of state funding) should be explicit and transparent to minimize market uncertainty and the risk of abuse.[11]

Partial ownership of AIG and major banks and control of Fannie Mae and Freddie Mac are most certainly not a renewed interest in old socialist ideas of the superiority of state run enterprises, actual experience with which has been almost universally bad. None-the-less, government share ownership increases the risks of political interference significantly. The longer it holds these shares the higher the risks will be and examples can be found already. And broad lending guarantees carry considerable risks of reintroducing the excessive risk taking by Wall Street that started this crisis. Emergency financial market stabilization measures should be ended as quickly as possible.

Charles Dallara, Managing Director of the Institute of International Finance, reported that banks receiving government capital injections have been told not to use the funds to satisfy the liquidity needs of their foreign subsidiaries.[12] The severity of the Great Depression is generally attributed to the failure of the Federal Reserve to provide liquidity to banks sufficient to prevent the collapse of the money supply, the ill conceived attempt to save American jobs with high tariffs embodied in the Smoot-Hawley Tariff Act of 1930, and the competitive devaluations around the world in self defeating efforts by each country to boost its exports. Fed Chairman Bernanke, a well versed student of the Great Depression, is determined not to repeat the Fed’s earlier mistake this time around and is thus providing hug amounts of liquidity to the financial system. All participants at the November 15, Washington Group of 20 (G-20) meeting on the financial crisis and international financial architecture have also confirmed the dangers of and their opposition to a new wave of protectionism. However, as Dallara, warns, the Treasury’s pressure on banks not to support their foreign subsidiaries with the Treasury’s capital injections could be the twenty first century’s version of misguided protectionism. It undermines the logic and premise of globalized banking organizations with a counterproductive effort to “keep capital at home.” Given that the U.S. government’s debt is largely financed by foreign capital inflows, this feature of the Treasury capital injection program (Troubled Asset Relief Program—TARP) is nothing short of shocking.

The purpose of the Wall Street “bailout” is to restore normal bank lending. However, too much pressure to lend runs the risk of recreating the conditions that produced the crisis in the first place (subprime loans to inappropriate borrowers). Banks should be left to exercise their best business judgment about how to use the new capital, and to whom to lend. Political interference in bank lending has almost always had a bad end around the world and the temptation and pressures on banks to favor districts or projects favored by their new government owners will increase with time. The positive contribution of recessions to our longer run economic health and productivity rests with the acceleration of sweeping away inefficient enterprises so that their capital and labor resources can be freed up to be used by more efficient firms. Some firms deserve to fail for the good of the rest of us and measures to “stabilize” the financial system should not interfere with that process more than necessary.

In addition to the nine large banks receiving $130 billion in capital under TARP, and additional 110 banks have asked for $170 billion under the governments bail out plan. The Treasury is now expanding the program to insurance companies and other Wall Street firms. But such larges is a slippery slope. Introducing the prospect of obtaining capital at more favorable terms than available in the market has brought a flood of lobbyists to Washington seeking funds for a wide variety of state and local governments and enterprises. The bankruptcy of a Main Street firm is quite different than of a financial intermediary and can be quite beneficial to the industry by reorganizing a firm or reallocating its assets to more productive hands. If the conditions for government money are made stringent enough (see Sweden’s experience with their bank bailouts in the early 1990s) those who can will find private money instead.[13] Thus government bailout money generally goes to the weakest and least deserving firms, though TARP is designed to try to avoid this usual outcome.

The most controversial appeal for government bailout money has come from Main Street firms like General Motors, Chrysler, and Ford. Detroit auto bosses would like to keep their jobs, of course, but the market is registering its displeasure at their inadequate performance. Beyond them and Big Three shareholders, the overpaid United Auto Workers are the main lobbyists for this bailout.[14] As we all know from the bankruptcies of Delta, United and other airlines, Chapter 11 reorganization does not necessarily mean the end of a firm. But it does void existing contracts (including labor contracts) and replace management in order to put together the good parts into a viable operation (if possible). American bankruptcy laws are well designed to guide the restructuring our Detroit auto firms (“old auto” rather than the more efficient and successful “new auto” manufacturing facilities for Toyota, VW and other foreign owned companies producing in the U.S.)[15] Among other things without a renegotiation of their labor contracts to more competitive levels, they are unlikely to survive. America also needs to honor commitments to the WTO regarding state subsidies to companies that sell internationally as part of our general commitment to the benefits of free trade.

The temporary partial nationalization of selected banks runs other political risks as well especially in Europe where the French President continues to talk of state support of “national champions”. Government supports (capital and guarantees), even when explicitly meant to be temporary, can be hard to remove and failing to do so would be very damaging to market discipline of bank risk taking. They have invariably tempted politicians to interfere to favor pet projects, firms, or relatives, the bane of state owned banks wherever they have existed.

Bank failures (as opposed to temporary illiquidity) are different than the failures of Main Street firms and require a special insolvency regime. For two decades the FDIC has effectively used its authority to resolve failing banks efficiently at minimum cost to the insurance fund and to tax payers and with minimal disruption to the market. While many judgments are required in it’s exorcise of this authority, the criteria on which they are based are explicit in the law (minimum cost to the fund) and can be monitored. Secretary Paulson’s Treasury’s interventions have not had that benefit and have increasingly raised questions about the seeming arbitrariness of some decisions. For example, why was Lehman Brothers allowed to fail while Bear Stearns and Merrill Lynch where “saved”?[16]

Many explanations have been offered. Lehman Brothers was smaller than the others and the markets had been given more time to adjust to and prepare for its bankruptcy and thus the market should be able to absorb it without systemic disruption. And it was time to restore market discipline. Another, not inconsistent, view is that Dick Fuld, CEO of Lehman Brothers, was an insider who overvalued his firm and arrogantly rejected the offers made by Barclays to buy it, while Merrill Lynch CEO, John Thain, come from the outside and had a more objective assessment of his firm’s real value and thus accepted the offer negotiated with Bank of America. But it is also impossible to escape the fact that Secretary Paulson was formerly the CEO of Goldman Sachs, a competitor of Bear Stearns, Lehman Brothers, and Merrill Lynch. A number of key Treasury officials also came from Goldman Sachs. His friend Warren Buffet bought $5 billion worth of Goldman’s perpetual preferred shares with a 10% dividend and an option to purchase $5B of common stock at $115 during the next five years. A cheaply priced capital injection by the Treasury should do nice things for Goldman’s share price.[17] Poor Lehman Brothers, on the other hand has large investments from George Soros, not a friend of Mr. Paulson or the Bush administration. The Washington Post claims that Paulson’s deal to sell Lehman to Barclays was actually killed by British regulators.[18][19]

The new program of assistance signed into law on October 3 and now focused on buying bank shares, is meant, in part, to replace this seemingly ad hoc approach to non bank financial institution resolution with a clearer set of rules and criteria. These rules seem still to be evolving. Both the U.S. approach and the UK/EU approaches dramatically reduce bank accountability for mistakes for the duration of partial government ownership. This period needs to be kept temporary. This is particularly important for guarantees of interbank loans. Normal dividend payments to other shareholders are suspended during the period of government share ownership.

The financial panic could have been ended overnight by a blanket government guarantee of all mortgage loans, however, the moral hazard would have been sever and public outrage over the gross unfairness of rewarding reckless speculators with the tax dollars of more prudent borrowers would surely have been pronounced. Bailing out such behavior would almost certainly bring on much more of it in the future. However, more carefully designed and targeted programs to help home owners able to make modestly reduced payments are already helping significant numbers avoid costly foreclosures. Bank of America, for example, reports that it has employed around 7,000 people to work full time on restructuring mortgages to help keep people in their homes (generally by lowering interest rates and thus monthly payments). They are willing to do so as long as the loss to them is less then would result from foreclosure.[20] Lenders are accepting a modest loss in order to avoid still larger losses. More can be done in this area, which would reduce banks’ mortgage related losses and thus improve their capital, but careful consideration must be given to the unfairness of bailing out poor judgments and providing an incentive to default in order to benefit.

Koppell and Goetzmann recommend that the government “pay off all the delinquent mortgages” by offering “to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent.” [21] McCain introduced a similar plan during the Presidential debates October 7. These proposals are bold but fail on many of the fairness, moral hazard criteria above. McCain’s plan spares the lenders any cost of their misjudgments and fully bails out borrows who can’t or won’t pay. A better plan, proposed by Henry Sanborn, is for the Federal government to offer to pay a share, say 30%, of the existing contractual mortgage payment in exchange for which the lender must pay (write off) a share, say 10% and the mortgagee the rest. The government’s payments would be a loan to struggling homeowners with attractive terms that encourage early repayment.[22] Replacing ARMs with Koppell and Goetzmann’s fixed rate mortgage could be usefully added to this plan. Actual and expected foreclosures should drop significantly to those levels that should not be prevented in any event and the market value of mortgages and mortgage backed securities would quickly increase, the associated losses to lenders decrease, and the capital of banks holding them increase.

To illustrate, a $200,000 30 year mortgage on a house valued at 220,000 with an initial teaser interest rate of 4% adjustable after two years, would require monthly principal and interest payments of $955 per month. After two years the remaining principle would be $192,812. If the interest rate on the adjustable rate mortgage (the category with the largest defaults) increased to 6% (most ARMs cap year to year adjustments at 2%), monthly payments would jump to $1,186 per month (or $1,440 per month at 8%), which might be more than the borrower could afford. Sanborn’s proposal is that if the lender can not agree on a voluntary restructuring satisfactory to the borrowing, the government would pay (as a loan) 30% of the monthly payments ($356) and the lender would eat (write off) 10% ($119) reducing the monthly payments for the borrower to $712. More likely that borrower would choose to borrow from the government the smaller amount needed to keep her payments at the affordable $955 per month. There is no firm data on the extent to which such measures would reduce mortgage defaults but it is likely to be considerable. Even if the market price of the house fell 20% to $180,000 (i.e. below the amount of the mortgage (serious home owners are not likely to walk away from their home as long as they can continue to make the monthly payments)

The case by case renegotiations now underway by Bank of America and others are the best targeted to individual situations but very labor and time intensive. Some what cruder standardized models for restructuring mortgages could be implemented much more cheaply and quickly though would probably cost lenders more. On November 13, Fannie Mae and Freddie Mac announced such a model they intend to use. FHFA Chairman James Lockhart expressed the hope that this model would provide a minimum standard for the industry.[23] FDIC Chairman, Sheila Bair would like to go further by sharing half of the losses of lenders from loan restructuring that meet standard criteria with the government. By increasing the interest rate or principle reductions that would still save the lender money compared with foreclosure as a result of sharing the cost with the tax payer, Ms. Bair estimates that around 1.5 million home owners could be helped.[24]

As the panic subsides, the current temporarily high demand for liquidity by banks subsides, and deleveraging in the rest of the financial sector runs its course, the Federal Reserve must be prepared to reabsorb the huge amount of base money it created as rapidly as it extended it. Doing so prematurely would risk deepening the recession much as the Fed did to cause the second wave of the Great Depression in the late 1930s. “Clear exit criteria for extraordinary interventions should be in place to help address moral hazard and limit the degree to which intervention substitutes for regular market functioning in the long term.”[25]


Scene 3 – The Way Forward

On with the recession

With the financial panic now under control and lending and lending rates gradually returning to normal, monetary and fiscal policy must focus on moderating the recession without preventing it from correctly long standing macro imbalances. American consumers have long saved too little (consumed too much) to finance investments in American technology and productive capacity (and the government’s excess spending). Large balance of payments deficits filled the gap but are not sustainable. To sustain or increase investment with higher private sector saving the new macro mix requires lower external deficits (smaller balance of payments deficits) and lower fiscal deficits. The fall in the exchange rate of the dollar for the Euro and most other world currencies to more realistic and sustainable levels has already started the process of adjustment by making American exports more competitive and imports more expensive. This reduced consumer spending (increased household saving) is being offset by increased foreign spending on American goods (increased exports). These are very desirable adjustments.

However, the dramatic and very large fall in household wealth as a result of falling real estate and stock prices is beginning to reduce household consumption more rapidly than it can be replaced by increased net exports (which includes shifting some consumption from foreign to domestically produced goods and services). The spread of America’s financial crisis abroad and the bursting of Europe’s own real estate bubbles is undercutting the recent increases in American exports as is the appreciation of the dollar’s exchange over the last four months.[26] In short, the adjustments needed within the American economy are not occurring as smoothly as they might have. Investment itself is retracting in the face of the credit crunch induced by financial turmoil and by falling demand. With falling consumption AND investment (rather than falling consumption with increased investment) and stalled growth in exports, only increased demand from fiscal policy (tax cuts or spending increases) can prevent a fall in aggregate demand from producing an increase in unemployment. In short, the American economy is in recession.

It is appropriate for monetary (lower interest rates) and fiscal policy (larger fiscal deficits) to attempt to moderate the recession in an effort to prevent overshooting. Automatic stabilizers, such as rising state and federal deficits as expenditures are maintained in the face of falling tax revenue and increased safety net expenditures for increased unemployment compensation, etc., are a first line of defense. But they might be usefully augmented by measures such as extending the period of eligibility for unemployment benefits and accelerating infrastructure expenditures that are needed in any event. Such fiscal measures, however, should not interfere with the broader macro economic adjustments needed (higher domestic saving and lower trade deficit) for long run sustainability. Nor should they thwart the healthy purging of inefficient firms and pruning of fat to keep viable firms efficient. The dynamism of the entry of new firms and the exit of unsuccessful (unprofitable) ones is a critical factor in our high and growing standard of living.

As noted about the Great Depression was caused by the failure of the Federal Reserve to provide sufficient liquidity to a distressed banking system and protectionist measures in the form of high import tariffs and competitive (and self defeating) currency devaluations around the world in what came to be called beggar they neighbor policies. These last elements call for policy coordination on a global basis and are discussed more fully in the next section in the context of future reforms of the system.


Reforming the system

It is still hard to believe that underwriters approved many of the loans now gone and going bad that have sparked the deleveraging frenzy driving the restructuring of the financial system and the current financial crisis. There are lessons to be learned that will surely involve additional or improved regulation. However, it is naive to say the least to think that government bureaucrats are generally better at spotting risks than those whose money is on the line.

Relevant industry groups are frantically at work seeking solutions that will reduce the prospects of such huge losses in the future. Regulatory bodies would do well to work with them, interfering only when industry self interest clearly conflicts with the broader public interest (easier said than done). Above all, adjustments and refinements to financial regulation should wait until we all have a better understanding of the existing weaknesses that can be fixed by regulation. It is too easy for new regulations to do more harm than good. The rush by the Securities and Exchange Commission (SEC) to ban short selling of traded stocks had among its unintended consequences a negative effect on corporate bond prices.[27] This “reform” is widely believed to have been a mistake. Even Mr. Bad Guy Regulator, Eliot Spitzer, former state attorney general (and Governor) of New York, speaks nicely of the importance of short selling for market discipline.[28]

It is a mistake to characterize the choice as between regulation or no regulation. Regulation comes in a wide variety of forms and degrees, some more aligned with requirement for market development and efficiency than others. Consider the exciting new technology and market for mobile phone payments. Using existing mobile phone accounts (unique phone number for each customer and arrangements for billing and paying for service), mobile payments add simple to use software to the instrument to sending payment instructions, a pass code for each number to authorize them, central deposit update and management software and registered points for receiving and paying out cash (in Kenya and Afghanistan the large preexisting network of air time salesmen are used though any merchant with a mobile phone can also be used). The combination of a unique phone number and pass code function in the same way as swiping a debit card and entering a pass code to pay a merchant from a customer’s bank account, but in the case of mobile payments payers and/or receivers do not need to have bank accounts.

The Vodafone system adopted in Kenya and Afghanistan and now being developed for Iraq is regulated, but not much beyond what the private providers of these services would demand of their customers to protect their operation. To satisfy Anti Money Laundering requirements, phone companies offering mobile phone payment services are required to “know their customers” (names and addresses) who are necessarily linked to their assigned phone numbers. This does not expand information requirements beyond what phone companies require to provide the phone service in the first place. The systems also set limits on maximum and minimum transfer amounts (per day, per transaction, per month), which again would surely be set even without regulation. The most intrusive regulation is that funds deposited in the system for transfer via mobile phones must be kept by the phone service operator in a trust account with a licensed bank and invested conservatively by that bank.[29] Modern market friendly approaches to regulation have left entrepreneurs free to develop and implement this service, imposing only enough regulation to protect the safety of the system and prevent its use for money laundering. It reflects the kind of relationship between government and the market that provides a good model for regulation more generally.

Areas where reforms are being discussed range from extending the legal tools found in American bank insolvency laws to a broader range of financial institutions, improving the “pluming” (back office processing and accounting) for Credit Default Swaps—CDSs—and other derivatives); limiting CDSs to those with the actual credit exposure being insured (i.e. banning naked CDSs), strengthening capital charges for CDSs, reducing or eliminating tax incentives for leverage (including the mortgage interest deduction from personal income tax), refining the treatment of on and off balance sheet items for bank capital adequacy, making rating agencies liable for their work to the same standard as auditors, to strengthening rules on broker/dealer/bank use of collateral.[30] More broadly solutions must be found for the break down of lending standards arising because private sector actors (brokers and agents) make decisions for fees with regard to other peoples money (should mortgage originators be required to keep some of the risk—to have some “skin in the game”—and should bonuses have to be structured to avoid rewording undue risk taking?). In addition, in the U.S. existing gaps in and poor coordination of financial sector supervision should be fixed by the reorganization of supervisory agencies and responsibilities.[31] Morris Goldstein of the Peterson Institute of International Economics has outlined 10 points for reform "Making the G-20 Summit Work: The ‘Ten-Plus-Ten’ Plan" that provide a good basis for discussion of what might be needed.

The focus of the Washington Summit of the G-20 heads of state November 15 on broad principles rather than specific “fixes” is in this spirit and is to be welcomed.[32]

“The Summit achieved five key objectives. The leaders:

  • Reached a common understanding of the root causes of the global crisis;
  • Reviewed actions countries have taken and will take to address the immediate crisis and strengthen growth;
  • Agreed on common principles for reforming our financial markets;
  • Launched an action plan to implement those principles and asked ministers to develop further specific recommendations that will be reviewed by leaders at a subsequent summit; and
  • Reaffirmed their commitment to free market principles.”

They fulfilled Fred Bergsten’s advice to first “do no harm.”[33] We can give a sigh of relief.

The G-20 Communiqué set out a work plan for reform that emphasized the importance of the coordination of monetary, fiscal and supervisory policies internationally and of the importance of the International Monetary Fund’s surveillance and financing roles and the need to ensure that it has sufficient resources. The Communiqué also stressed the need to better balance the voting strengths of member countries in the IMF and World Bank with their current economic importance in the world. This implies a reduction in European country quotas and increases in China, India, and Brazil among other emerging countries. The United States long ago gave up some of the quota it would be entitled to on the basis of its economic size.

The coordination of policies is important to avoid the competitive devaluations of the 1930s that were one of the contributing factors to the severity and duration of the Great Depression. It was precisely for such purpose that the IMF was created at Bretton Woods following World War II. Similarly its recent loans to Iceland, Ukraine and Hungary are classic uses of the IMF’s resources to supplement for the sudden drop in international capital flows that are part of the current crisis.

The G-20 has set out a sensible work plan for reviewing the lessons of the subprime crisis and developing reforms needed to strengthen the global trading system. It is hard to find fault with Communiqués statement that:

“12. We recognize that these reforms will only be successful if grounded in a commitment to free market principles, including the rule of law, respect for private property, open trade and investment, competitive markets, and efficient, effectively regulated financial systems.  These principles are essential to economic growth and prosperity and have lifted millions out of poverty, and have significantly raised the global standard of living.  Recognizing the necessity to improve financial sector regulation, we must avoid over-regulation that would hamper economic growth and exacerbate the contraction of capital flows, including to developing countries.”


“13.  We underscore the critical importance of rejecting protectionism and not turning inward in times of financial uncertainty.  In this regard, within the next 12 months, we will refrain from raising new barriers to investment or to trade in goods and services, imposing new export restrictions, or implementing World Trade Organization (WTO) inconsistent measures to stimulate exports.”

As always, the out come of these efforts will depend on the details developed over the coming months.

[1] Wall Street insiders I have discussed this with speak of a dramatic sea change in attitudes toward risk taking following adoption of the Gramm-Leach-Bliley Act in 1999, which repealed the Glass Steagall Act. The immediate performance bonus system found in investment banks and totally alien to commercial banks encouraged a hit and run attitude toward taking commissions and annual bonuses with little regard for the longer term viability of the exotic instruments being created.

[2] See Coats. “The U.S. Mortgage Market: the Good, the Bad and the Ugly,” Association of Banks in Jordan, June 22, 2008; “Fannie and Freddie: More Good, Bad and Ugly.” July 31, 2008.

[3] Any cost to the lender from reducing the interest rate or other terms of a mortgage to avoid foreclosure that was less than its loss from foreclosure (estimated currently at between 25 to 40% of the mortgage) potentially “saved” it money.

[4] On November 25, 2008 the Federal Reserve added a “Term Asset-Backed Securities Loan Facility” (TALF). The facility will lend to any U.S. person for one year against the collateral of Asset Backed Securities (ABS) that consist of “auto loans, student loans, credit card loans, or small business loans guaranteed by the U.S. Small Business Administration.”

[5] American International Group (AIG), for example, sustained large losses on Credit Default Swaps it had issued (insurance on the default of MBSs). It was taken over by the government to avoid bankruptcy.

[6] In early October the IMF estimated world wide losses from American mortgages and mortgage related securities would reach $1.4 billion of which about half have already been written off. Reported in The Economist, October 11, 2008 “A Special Report on the World Economy” p 4.

[7] See Coats, “The D E Fs of the Financial Markets Crisis,” CATO Institute, September 26, 2008.

[8] Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets, Sec. 2.

[9] Virtually every category of American bank lending, including interbank loans, have increased over the past year through Oct 22 with a small decline in most categories on Oct 29, 2008 (See FRB H-8). Lending declined modestly and temporarily for several months last Spring. However, the composition of such lending changed away traditional business customers and the much larger and more important non bank credit market for corporate credit (e.g. commercial paper market) fell into great difficulty. Huge withdrawals from Money Market funds, a major buyer of commercial paper, were only slowed by a quick government guarantee of the principle deposited in such funds. The market dramatically accelerated the rearranging of the complex linkages through which regular credit flowed. While borrowers and lenders can ultimately adjust to new channels and linkages, the pace with which the (deleveraging) changes were happening could not be easily accommodated without serious disruptions to Main Street enterprises suddenly cut off from normal credit. A very useful discussion is presented in the IMF’s Global Financial Stability Report of October 2008 "Financial Stress and Deleveraging, Macrofinancial Implications and Policy"

[10] "Rescuing the Banks: We have a plan" The Economist, October 11, 2008, p 75.

[11] The ill conceived initial plan to buy toxic MBSs from certain banks has now given way to the use of Treasury’s new authority to inject capital into certain American banks. Peter Whoriskey, David Cho and Binyamin Appelbaum, "Treasury Redefiness Its Rescue Program" The Washington Post, Nov 13, 2008 P A01

[12] The Bretton Woods Committee meeting on the “New Global Financial Architecture”, November 12, 2008, Washington DC.

[13] Warren Coats, "The Big Bailout – What Next?" Cato Institute, October 3, 2008

[14] Jeffrey Mccracken and John D. Stoll, "GM Blitzes Washington in Attempt to Win Aid", Wall Street Journal, November 15, 2008.

[15] The Washington Post Editorial, "No Free Lunch" November 14, 2008, P A14; Daniel J. Mitchell, "Say No to the Auto Bailout" November 13, 2008; Thomas L. Friedman, "How to Fix a Flat", The New York Times, November 11, 2008; Martin Feldstein, "A Chapter for Detroit to Open", The Washington Post, November 18, 2008, Page A27; Kevin A. Hassett, "Recession will be less Damaging without Bailouts", AEI, November 17, 2008.

[16] As noted earlier this characterizations of what happened is an over simplification.

[17] U.S. Treasury, TARP Capital Purchase Program, Senior Preferred Stock and Warrants “The Senior Preferred will pay cumulative dividends at a rate of 5% per annum until the fifth anniversary of the date of this investment and thereafter at a rate of 9% per annum.”

[18] David Cho, "A Conversion in ‘This Storm’" (the Evolution of Hank Paulson), The Washington Post, November 18, 2008. Page A01.

[19] Similar questions have been raised about the role played by Robert Rubin in supporting the repeal of the Glass Steagall Act that made possible the merger of Citibank, Travelers Insurance and Salomon Smith Barney (a bank, an insurance company and an investment bank) to form Citigroup. When he left the Clinton administration Rubin accepted a highly paid position as a Director and Senior Counselor of Citigroup. Steven Pearlstein, "A Bailout Steeped in Irony", The Washington Post, November 25, 2008, Page D01.

[20] Gregory Baer, Deputy General Counsel at Bank of America, in a presentation at the New America Foundation November 13, 2008.

[21] Jonathan G.S. Koppell and William N. Goetzmann, "The Trickle-Up Bailout", The Washington Post, October 1, 2008; Page A17

[22] Henry N. Sanborn, “A Different Solution to the Financial Mess” unpublished

[23] Patrick Rucker, "GSE Chief says Mortgage Aid Plan Should be Model" Reuters, November 13, 2008.

[24] FDIC, "FDIC Loss Sharing Proposal to Promote Affordable Loan Modifications"; Alan Zibel, "FDIC says plan could help 1.5 million keep homes", Associated Press November 14, 2008.

[25] IMF, “Global Financial Stability Report: Financial Stress and Deleveraging Macrofinancial Implications and Policy”, International Monetary Fund, October 2008

[26] The dollar peaked on July 6, 2001 when it exchanged for 1.19 Euros. Seven years later on July 16, 2008 it had fallen 47.5% to 0.63 Euros. Since then it as appreciated 22% (to 0.08 on October 29) but was still 33% below its 2001 peak.

[27] The Economist, "Hedge funds: Collateral Damage", October 9, 2008.

[28] Eliot L. Spitzer, "How to Ground the Street" The Washington Post, November 16, 2008 Page B01.

[29] Aleeda Fazal, Task Force to Improve Business & Stability Operations in Iraq

[30] The Economist, "Prime Brokers: Do the brokey-cokey" Oct 23, 2008

[31] American organization of its supervision clearly needs to be restructured along the lines proposed by Secretary Paulson in March of this year.

[32] White House: "Fact Sheet: Summit on Financial Markets and the World Economy" November 15, 2008.

[33] C. Fred Bergsten, "Stopping the Global Meltdown", The Washington Post, November 12, 2008, Page A19