Thursday May 6, 2010
IPE Leiden

Agustin Mackinlay

Session 6. The Political Economy of China’s Economic Development Strategy
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[1] ON SOME ISSUES FROM SESSION 5

[2] THE SPIRIT OF THE DOOLEY, FOLKERTS-LANDAU & GARBER PAPER

[3] DOCUMENTS!

[4] TEXT OF NEW ASSIGNMENT

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[1] ON SOME ISSUES FROM SESSION 5

Two quotes from Winston S. Churchill. Marlborough. His Life and Times, Vol. II [1938] (The University of Chicago Press, 2002), pp. 506, 507, 652.

All Europe marvelled that in the seventh year of so great and costly a war, when every other state was almost beggared, if not bankrupt, the wealth of England proved inexhaustible. Indeed, it seemed that the government held a magic purse. The yield of high taxation was reinforced by internal borrowing upon the largest scale yet known. The Bank, in exchange for a twenty-one years' extension of their charter, bound themselves to provide four hundred thousand in cash and issue two and a quarter millions of bank-bills. Within four hours of nine o'clock the whole amount was subscribed, and eager would-be lenders were turned away in crowds.

Then Churchill cites from diplomatic sources:

Outside England it would appear incredible for this nation, after it had provided four hundred million Reichsthaler during nearly twenty years of war, to be able to produce a further ten millions in a few hours at the low rate of interest of 6 per cent. It must be observed that this has not been done in cash, which is now difficult to obtain, but in paper, particularly bank notes. Indeed, not a penny of these ten millions was paid in cash, but all in banknotes. These banknotes circulate so readily here that they are better than hard coin. So the whole of this wealth appears to be based almost entirely upon the credit of the paper money and the punctual payment of the interest. These prodigies … the City’s mysterious power of manufacturing credit…

Meanwhile, the king of France has to finance the war effort through taxes that are often collected manu militari. Louis XIV does not rely on French Parlements, and cares little about judicial independence. England’s monetary and credit might must have deeply impressed her enemies…
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[2] THE SPIRIT OF THE DOOLEY, FOLKERTS-LANDAU & GARBER PAPER

. It is really important to understand the spirit of the article, more than its technicalities. Key points: Europe/Japan 1945 & China 1980s; stock of productive capital & institutional strength; center-periphery dynamics; cost of capital & cost of labor; second best; the international reserve currency.
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[3] DOCUMENTS

Document 1 [REQUIRED READING!]

IN FAVOR OF THE INTERNATIONAL RESERVE CURRENCY SYSTEM. Michael Dooley, David Folkerts-Landau & Peter Garber: “An Essay on the Revived Bretton Woods System”, NBER Working Paper No. 9971, September 2003

. These are the most important parts of the paper:

1. In this paper we explore the idea that the global system that has evolved and grown since the advent of Bretton Woods has maintained a single dynamic structure. In the Bretton Woods system of the 1950s, the US was the center region with essentially uncontrolled capital and goods markets. Europe and Japan, whose capital had been destroyed by the war, constituted the emerging periphery. The periphery countries chose a development strategy of undervalued currencies, controls on capital flows and trade, reserve accumulation, and the use of the center region as a financial intermediary that lent credibility to their own financial systems. [Comment: note the center-periphery dynamics!]

2. Once the capital of these zones had been rebuilt and their institutions restored, the periphery graduated to the center. It had no further need for the fixed rate, controlled development strategy, especially when it perceived that the US, in performing its financial intermediation service, was reaping a large transfer payment. [Comment: a periphery can graduate and become a center of innovation! How can they accomplish that?]

4. We emphasize the idea that it has been a successful development strategy to subordinate the objective of maximizing the value of reserve assets in order to subsidize and build a domestic capital stock capable of competing in international markets. This is not a first best strategy. It would be better to have both an internationally competitive capital stock and reserves that were superior investments. [Comment: (1) central banks who apply the BWII strategy care mostly about keeping their currencies undervalued; they care less about the profit/loss profile of their dollar holdings; (2) the “second best idea”: discussion]

5. When Europe’s development strategy shifted toward free markets, financial controls were lifted and the fixed rate system soon collapsed into the floating regime of the 1970s. [Comment: Western Europe and Japan did graduate from periphery to center! Center & periphery are thus very much dynamic variables!]

6. Most other developing countries, particularly the newly decolonized states, flirted with socialism or systems of import substitution that closed them off from the center. This development strategy was inhospitable to trade and the importation of long-term foreign capital. It fostered a local production of goods that could not compete globally and therefore built an inefficient capital stock that would in the end have little global value. Just as in the communist countries, when these opened to world trade and capital flows, they discovered that their cumulated capital was fit only to be junked. That is, they were in the same real capital-poor position as the post-war European countries. [Comment: a very powerful analogy! Europe/Japan 1945 & communist countries 1980s…]

7 and 8. With the discrediting of the socialist model in the 1980s and then the collapse of communism in 1989-91, a new periphery was melded to the US-Europe-Japan center. These countries were newly willing to open their economies to trade and their capital markets to foreign capital. These countries all were emerging from decades of being closed systems with decrepit capital stocks, repressed financial systems, and a quality of goods production that was not marketable in the center. The Washington Consensus encouraged them in a development strategy of joining the center directly by throwing open their capital markets immediately. [Comment: (a) a new periphery!; (b) why “repressed financial systems”? (remember Session 3); (c) what’s the Washington Consensus?]

9. Others, mainly in Asia, chose the same periphery strategy as immediate post-war Europe and Japan, undervaluing the exchange rate, managing sizable foreign exchange interventions, imposing controls, accumulating reserves, and encouraging export-led growth by sending goods to the competitive center countries. [Comment: that’s China, ladies & gentlemen!]

10. It is the striking success of this latter group that has today brought the structure of the international monetary system full circle to its essential Bretton Woods era form. The Europe-Japan of the 1950s was already large enough so that in our analyses we did not have a "small country" view of the periphery but rather recognized it as the driving force of the international monetary system. Now the Asian periphery has reached a similar weight: the dynamics of the international monetary system, reserve accumulation, net capital flows, and exchange rate movements, are driven by the development of these periphery countries. The emerging markets can no longer be treated as small countries, weightless with respect to the center. At some point, the current Asian periphery will reach a developmental stage when they also will join the center and float. But that point will not be reached for perhaps 10 more years and, most likely, there will be at that time another wave of countries, as India is now doing, ready to graduate to the periphery. [Comment: a bold forecast! Was it successful?]

11. Fixed exchange rates and controlled financial markets work for twenty years and countries that follow this development strategy become an important periphery. These development policies are then overtaken by open financial markets and this, in turn, requires floating exchange rates. The Bretton Woods system does not evolve, it just occasionally reloads a periphery. [Comment: some ‘timing’ issues]

15. In general we know that the US current account would have to adjust if the international monetary system consisted of floating currencies and open capital markets. But we do not live in such a world. We have re-entered a Bretton Woods reality and have to relearn and understand the very different adjustment requirements for the center country in such a system. [Comment: this is the only relevant technical point. We shall talk about the adjustment process]

18. … exporting to the US is Asia’s main concern. Exports mean growth. When their imports do not keep up, the official sectors are happy to buy US securities to finance the shortfall directly, without regard to the risk/return characteristics of the securities. Their appetite for such investments is, for all practical purposes, unlimited because their growth capacity is far from its limit. [Comment: they want exports above all! They are less worried about the value of their foreign exchange reserves]

22. The US … wants finance for its own growth and foreign savings help finance domestic capital formation. [Comment: innovators need capital!]

25. Asian countries in particular (China, Taiwan, HK, Singapore, Japan, Korea, Malaysia) manage their dollar exchange rates; and, as such, they float against the capital account region. Official capital exports finance growth-oriented trade surpluses. Policy is often affected through a system of exchange controls and administrative pricing. Some currencies are explicitly and rigidly fixed (RMB, HKD, MYR); others (JPY, KRW) “float” but still accumulate vast amounts of official reserves in USD. [Comment: central banks recycle trade surpluses back into the US credit markets]

28. In spite of the growing US deficits, this system has been stable and sustainable. The current account structure and asset accumulation have been consistent with the trade account region’s preferences for official investments in the US and, until early this year, the capital account region’s preferences for private financial investments in the US. But as US debts cumulate, US willingness to repay both Asia and Europe comes more naturally onto the radar screen, so the system that was previously stable could run into trouble. [Comment: the system is clearly under pressure now …]

34. Asia’s proclivity to hold US assets does not reflect an irrational affinity for the US. Asia would export anywhere if it could and happily finance any resulting imbalances. But the US is open; Europe is not. Europe could not absorb the flood of goods, given its structural problems and in the face of absorbing Eastern Europe as well. So Asia’s exports go to the US, as does its finance—otherwise, a US, if faced with financing difficulties, might similarly tend toward more stringent commercial policy. Asian officials are unlikely to shift toward Euro assets because of the depressing effect this would have on trade with the US. [Comment: in other words, the US dollar is the key international reserve currency]

35. The irony here is that concern of investors in the capital account region about the risk/return in an increasingly indebted US is misplaced. The US is being underwritten by Asia for the foreseeable future. [Comment: surely a bit too optimistic in light of subsequent events…]

38. More generally, emerging markets now have a choice … If they follow the Asian model, they will do whatever it takes to limit exchange rate changes relative to the dollar and to keep their currencies undervalued to spur exports. The two tools available are controls and taxes on capital inflows and intervention in the foreign exchange markets to peg an undervalued currency. [Comment: as we shall see, to “intervene in the foreign exchange markets” means to finance the US budget deficit]

41. We used to have a view that 1) there was a system (Bretton Woods) that evaporated thirty years ago into no system at all and 2) now a semi-system has emerged anew. But, in fact, the system has been the same throughout, just manifesting itself in different forms because the original emerging markets (Europe and Japan) developed and did not need the center’s intermediation any more. There was no one to replace these countries for two decades. But with the collapse of socialism came a new litter of emerging markets, and the background system that is the incubator of such economies has reanimated itself. [Comment: the “renewed Bretton Woods”, or “Bretton Woods II”]

42. So we can anticipate some issues that were familiar 50 years ago returning to center stage of the economics of international finance. Can the center survive with two reserve currencies? As the dollar replaced sterling as the preferred reserve currency, will the euro replace the dollar? How long can trade account countries insulate their domestic financial markets through capital controls? Does the system benefit and entrench the economic and geo-political power of the center country (i.e. the DeGaulle-Rueff view)? [Comment: we’ll quickly mention the DeGaulle-Rueff view]
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Document 2 [REQUIRED READING!]

AGAINST THE INTERNATIONAL RESERVE CURRENCY SYSTEM DURING THE BRETTON WOODS ERA. Jacques Rueff. Le péché monétaire de l’Occident. Paris: Plont, 1971

The process works this way. When the U.S. has an unfavorable balance with another country (let us take as an example France), it settles up in dollars. The Frenchmen who receive these dollars sell them to the central bank, the Banque de France, taking their own national money, francs, in exchange. The Banque de France, in effect, creates these francs against the dollars. But then it turns around and invests the dollars back into the U.S. Thus the very same dollars expand the credit system of France, while still underpinning the credit system in the U.S.

The country with a key currency is thus in the deceptively euphoric position of never having to pay off its international debts. The money it pays to foreign creditors comes right back home, like a boomerang … The functioning of the international monetary system is thus reduced to a childish game in which, after each round, the winners return their marbles to the losers … The discovery of that secret [namely, that no adjustment takes place] has a profound impact on the psychology of nations (la psychologie des peuples) … This is the marvelous secret of the deficit without tears, which somehow gives some people the (false) impression that they can give without taking, lend without borrowing, and purchase without paying. This situation is the result of a collective error of historic proportions.

For more details on Charles de Gaulle, Jacques Rueff and the “dollar battles” of the 1960, you can see [NOT required reading!]: Christopher S. Chivvis: “Jacques Rueff and French International Monetary Policy under Bretton Woods”, Journal of Contemporary History, Vol. 41, No. 4, October 2006, pp. 701-720; Francis J. Gavin. Gold, Dollars, & Power. The Politics of International Monetary Relations, 1958-1971 (The University of North Carolina Press, 2005); Agustin Mackinlay: Charles de Gaulle and the ‘Deconstruction of the Dollar’, unpublished thesis, University of Amsterdam, 2005.
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Document 3 [NOT REQUIRED READING!]

UNDERSTANDING THE ADJUSTMENT PROCESS

Understanding the Adjustment Process: the Gold Standard Regime

Step1. Trade surplus. A Dutch exporter sells porcelain crafts to English consumers. He gets paid with a £ Bank note issued by the Bank of England (BoE). But he needs either gold or Dutch guilders to pay his workers and other expenses. Thus, he goes to the Bank of Amsterdam and sells his £; he gets a Certificate of Deposit in return:

Dutch exporter Bank of Amsterdam
. less £ Bank Notes . more £ Bank Notes (assets)
. more CDs (assets) . more CDs (liability)

Step 2. Conversion into gold. The Bank of Amsterdam the goes to the Bank of England to get gold:

Bank of Amsterdam Bank of England
. less £ Bank Notes . less £ Bank Notes (liabilities)
. more Gold (assets) . less Gold (assets)

Step 3. The Adjustment process. The Bank of Amsterdam can make more loans; the Bank of England makes less loans. Interest rates decrease slightly in the Netherlands (more supply of loanable resources) and increase slightly in England (less supply of loanable resources). Wages, consumption and imports tend to rise in the Netherlands; wages, consumption and imports tend to decrease in England. Large deficits are thus quickly corrected through permanent inflows/outflows of gold.

Understanding the adjustment process: China & the USA: the international reserve currency

Step 1. China’s trade surplus. A Chinese exporter sell toys to US consumers. He gets paid in US$. But he needs Yuan to pay for his workers’ salaries and other expenses. He goes to his bank in Shanghai and sells his US$; he gets Yuan in return:

Chinese exporter Bank of Shanghai
. less US$s . less Yuan (assets)
. more Yuan . more US$s (assets)

The Bank of Shanghai then goes to the People’s of China (the Chinese central bank) to get Yuan:

Bank of Shanghai People’s Bank of China
. less US$s (assets) . more US$s (assets)
. more Yuan (assets) . more Yuan (liabilities)

Step 2. The critical move. Instead of selling their dollar, or converting them into gold, the People’s Bank of China buys U.S. Treasury securities from American banks in … New York City! The People’s Bank of China buys U.S. Treasury securities from JP Morgan in New York City:

People’s Bank of China JP Morgan
. less US$s notes (assets) . more US$s notes (assets)
. more U.S. Treasury bonds (assets) . less U.S. Treasury bonds (assets)

This is the key feature of a monetary system that depends on an international reserve currency. Surplus countries channel their foreign currency assets back into the credit market of the country that issues the international reserve currency. They do that for a variety of reasons. Unlike gold (which doesn’t pay interest), U.S. Treasury securities do pay interest; besides, there is a very large market for these securities, which means that the People’s Bank of China has at all time easy access to its funds (this feature of U.S. Treasury securities is sometimes called ‘liquidity’).

From an economic point of view, the key thing to remember is the following: the People’s Bank of China does not sell its dollars, nor does it convert them holdings into gold (as surplus countries used to do under the Gold Standard Regime). And because the People’s Bank of China invests those surplus dollars into U.S. credit markets, there is no adjustment through higher interest rates in America! The supply of loanable resources increases in the United States. Thus no adjustment takes place. Because the People’s Banks does not sell, the dollar does not fall in value, which means that wages are kept (artificially) low in China; and because interest rates in the US do not rise, income and wage levels are kept (artificially) high in America. Surpluses accumulate!

(If this was not enough, the People’s Bank may sell bonds to Chinese banks to tighten credit conditions back in China.)

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Document 4 [NOT REQUIRED READING!]

ON THE GROWTH OF CHINA’S FOREIGN EXCHANGE RESERVES. The Financial Times quotes economist Brad Setser, who analyzes the growth of China’s dollar reserves (*):

The explosion in China’s foreign exchange reserves has been one of the more remarkable episodes in recent financial history. The official total is $1,950 billion, but Brad Setser, of the Council on Foreign Relations, a New York-based think tank, who tracks China’s foreign assets, puts the real figure at nearer $2,300 billion – equivalent to more than $1,600 for every Chinese citizen. From that total, Mr Setser calculates that about $1,700 billion is invested in dollar assets, making the Chinese government by far the largest creditor of the US. Last year, when its economy was under extreme stress, China lent to the US more than $400 billion – equivalent to more than 10 per cent of Chinese gross domestic product. “Day after day, China is the single biggest buyer of Treasury bonds in the market”, he wrote in a recent report. “Never before has the US relied so heavily on another country’s government for financing”.

(*) Geoff Dyer: “China’s dollar dilemma”, Financial Times, February 23, 2009.
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Document 5 [REQUIRED READING!]

THE CRISIS & THE INTERNATIONAL RESERVE CURRENCY. Brad Setser: “Bretton Woods 2 and the current crisis: any link?”, Council on Foreign Relations, December 1, 2008

The current financial crisis has produced its share of surprises even to those who doubted the long-term health of a housing-centric US economy. International economists – at least some of them – have long worried about the risk of a breakdown in what former Treasury Secretary Summers labeled the balance of financial terror and what others have called the “Bretton Woods 2” system of fixed exchange rates — a system where the rapid growth of central bank reserves in China and the oil-exporting economies financed large deficits in the US. They expected a crisis that marked by a fall in the dollar, a loosening of China’s peg to the dollar, a rise in the currencies of key emerging economies and higher interest rate on the US governments borrowing. The current crisis has not followed script: it has been defined by a rise in the dollar, a tightening of China’s peg, a sharp fall in emerging market currencies and fall in the US governments borrowing costs.

In a deep sense, the current crisis has been a crisis in an international financial system defined by the buildup of large surpluses among emerging market governments, a buildup that financed heavy borrowing by American and European households. Defenders of this system argued that it was win/win. China could develop on the back of its exports. They argued that the US and Europe benefited from low and stable interest rates – a constellation that justified heavy borrowing by households and high prices for a host of risky financial assets; unbalanced world need not be a risky world; China (and the Gulf) saved so that the US didn’t have to. Conversely, the US households spent so that China’s government didn’t have too – Menzie Chinn of the University of Wisconsin has accurately noted that the great puzzle of the past few years is why China preferred subsidizing US consumption to subsidizing Chinese consumption.

Crises have a way of clarifying the weak links in any financial arrangement. This crisis is no different. China didn’t actually finance US household borrowing directly. Rather China bought US Treasury bonds. But the inflow from China was still central to the process that allowed the extension of credit in an economy that itself wasn’t saving, and thus wasn’t generating new funds to lend. Think of it this way: when China bought a Treasury bond from an American insurance company or bank, if provided the pension fund or bank with funds to invest in riskier assets that offered a higher yield than Treasury bonds. Wall Street proved more than capable of churning out ever more complex kinds of mortgage backed securities – and securities composed of parts of other mortgage backed securities – to meet this demand.

The flow of credit that allowed American households to keep buying Chinese goods even as they were spending more on imported oil hinged on the willingness of China’s government to take currency risk – converting China’s domestic renminbi savings into demand for US government and agency bonds – and the willingness of Americans to trade their holdings of safe government bonds for riskier, and higher yielding, mortgage backed securities. That meant that American (and, as it turned out European) financial institutions took on ever increasing amounts of credit risk even as China allowed an ever rising share of its national savings to be denominated in dollars. Economists worried that the first leg of the trade might not be stable – China and others might not always be willing to buying depreciating dollars. It turned out though that the second leg of this trade was even more unstable – and even more risky. China’s Treasuries aren’t likely to hold their value in terms of China’s own currency – but China will get more back than those who bought CDOS composed out of subprime mortgages – or the holders of Lehman’s bonds.

The collapse of confidence in US and European financial intermediaries consequently has brought down a key pillar of a global system that allowed emerging markets to grow on the back of American and European demand for their products. American households cannot borrow against their homes – and thus cannot continue to consume more than they earn. In September 2008, US consumption fell sharply – and it would take a brave man to forecast a different outcome for October. China no longer can rely on US and European demand for its exports to drive its own economic development. Unusually strong global growth over the past few years may be offset by an unusually strong global slowdown. The entire global economy is now slowing sharply.

In the long-run, the challenge will be to find a more sustainable basis for global growth. The last few weeks have once again illustrated the difficulties emerging economies looking to finance fast growth by borrowing from the international banking system face. But the past few months have also highlighted the costs of a world where rapid reserve growth in the emerging world finances heavy borrowing by US and European households. US and European taxpayers have been hit with the bill created when their banks lent against inflated home values; Chinese taxpayers will eventually be hit with the bill for borrowing in a currency that is going up (the RMB) to buy currencies (the euro as well as the dollar) that are going down. No one is going to win. The policies of the past few years have not worked; it is time to try something new.
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Document 6 [NOT REQUIRED READING!]

A NOTE ON THE CHINESE CURRENCY. Paul Krugman: “What’s in a name?”, The New York Times, 23 October 2009

Renminbi is the name of China’s currency; but yuan is the denomination of bills, the unit in which prices are measured, etc.. The closest parallel I can think of is Britain’s currency, which is sterling, but whose unit is the pound. In the case of Britain, however, everyone is easy on talking about the pound’s value, the pound’s exchange rate, and so on; if you talk about sterling’s value, most non-Britons will have no idea what you’re talking about. But for whatever reason, using yuan in the same way draws disapproval. But here’s the thing: talking about the number of renminbi per dollar is also, as I understand it, wrong — as wrong as talking about the number of sterling per dollar. Renminbi is the currency, but not a unit of the currency.
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Document 7 [REQUIRED READING!]

DID THE INTERNATIONAL RESERVE CURRENCY SYSTEM CAUSE THE CRISIS? LEHRMAN & MUELLER SAY “YES”. (IT’S A “CURSE”!) Lewis E. Lehrman & John D. Mueller: “Go Forward to Gold. How to lift the reserve-currency curse”, National Review, 15 December 2008

The most disturbing aspect of the current financial crisis is that no U.S. official has correctly identified its primary cause. Experts variously attribute the economic reverses to subprime lending, derivative trading, excessive leverage, and regulation that was either too lax or too strict (take your pick), but these are symptoms rather than causes. Ignored is the main culprit: the dollar’s role as the world’s main official reserve currency. Though he almost certainly doesn’t realize it yet, President-elect Barack Obama will either set the dollar’s reserve-currency status on the path to extinction or risk becoming the next victim of what we call “the reserve-currency curse.”

Official reserves are money held by governments and central banks for the settlement of international payments. A Spanish bank may not want to accept Indian rupees, and it might be inconvenient for Qatar Petroleum to accept Mexican pesos for a million barrels of oil. An official reserve currency is one everybody agrees to accept, and right now that currency is the dollar. But foreign-exchange reserves are commonly held in the form of government debts of the nation that issued the currency. In the case of the United States, that includes all those government bonds piling up in China and elsewhere. The problem is that, unlike gold, official dollar reserves increase the money supply in one country without decreasing it in another.

To understand how the dollar’s reserve-currency role helped cause the recent bubbles, and the ensuing crisis in the world financial system, we must apply the analysis of the great French economist and central banker Jacques Rueff, who was the first to explain the process. As a financial attaché in London in the early 1930s, Rueff witnessed the collapse of the post–World War I monetary system. He correctly diagnosed the stock-market boom of the 1920s, and the subsequent crash and price deflation, as the result of massive official accumulation — and subsequent liquidation — of foreign-exchange reserves. Foreign countries’ dollar reserves were certainly not the only factor involved, but before and during the Depression they were large enough to play a decisive role.
Many years later, in the 1960s, Rueff correctly predicted (and tried to prevent) the breakdown of the dollar-based Bretton Woods system. This 1944 agreement made the gold-convertible U.S. dollar the official reserve currency of the world monetary regime; it also fixed exchange rates within narrow limits. When the U.S. abandoned gold convertibility in 1971, thereby eliminating fixed exchange rates, the dollar’s reserve-currency role expanded sharply; without gold backing the system, it became a question of confidence, and the world had confidence in the dollar. Rueff died in 1978, but today’s international monetary system — based on the paper dollar, which is backed by nothing but faith in the American economy — has the same potentially fatal flaw that he pointed out in two earlier gold-exchange standards. As was true in the 1920s and the 1960s, the dollar’s reserve-currency role has led to the main pathologies that now plague the world economy: the speculative “hot money” flows that first inflated and then deflated stock, bond, and real-estate prices; the sharp rise and fall of commodity prices, especially of oil and other energy commodities; Congress’s apparently incorrigible fiscal irresponsibility; and the mushrooming U.S. deficit in international trade and payments.

The key difference between a reserve-currency system and the gold standard is that foreign-exchange reserves, in the form of government bonds, are not only assets of the national authority that holds them, as gold was; they are also (unlike gold) debts of the country that issues them. Thus, when foreign monetary authorities acquire U.S. debt securities as reserves, U.S. monetary authorities are, in effect, borrowing the same amount.

Congress has become increasingly addicted to reserve-currency finance by a kind of fiscal version of Parkinson’s Law: Public spending expands to absorb all available tax revenues. Working in tandem with this is Parkinson’s Debt Corollary: Public borrowing expands to absorb all available means of finance. In other words, the government will borrow as much as it can from whoever will lend to it. If tax revenues are Congress’s “allowance” (as Milton Friedman, envisioning Congress as a spendthrift teenager, once put it), then purchases of Treasury securities (by U.S. government trust funds and by the domestic and foreign banking systems) are its “credit cards.” But the congressional teenager’s spending won’t be constrained by a cut in allowance unless the indulgent parents also cut up the credit cards.

Consider the evidence. The federal government’s general operating deficit from 1980 through 2007 has averaged 4.2 percent of GDP. Federal investment in government-owned assets like office buildings and warships represented about 1.3 percent of GDP; this part of the deficit was almost exactly equaled by federal borrowing from non-bank private investors. Current federal consumption of goods and services, meanwhile, has accounted for the remaining 2.9 percent of GDP. About a third of this was funded (mostly) by foreign central banks, and two thirds by spending government trust-fund surpluses to fund the general operating budget — thus expanding the budget while masking the deficit. Relying on currency-reserve financing to expand government spending for current consumption is the wrong prescription.

Similar facts explain why U.S. international trade has swung from a chronic surplus in the early 1960s to a chronic and growing deficit ever since. Increased American consumption and reduced saving have caused an increasing U.S. current-account deficit, and therefore an equal surplus in countries that acquire dollar reserves.
These international imbalances consist almost entirely of goods and services purchased from foreign producers, ultimately paid for by federal deficit spending and financed largely by U.S. official borrowing from foreign monetary institutions.

The dollar’s reserve-currency status provides short-term political advantages to U.S. congressmen seeking reelection, but these are far outweighed by the perennial disruptions it has caused to the world and U.S. economy and to financial markets. There has also been a heavy political cost for presidents whose well-intentioned and sophisticated advisers have not, for two generations, grasped the perversities of the dollar-based world monetary system. This is why the Fed has been surprised repeatedly by large changes in U.S. prices, including housing-price deflation, stock-market selloffs, and commodity-price gyrations.

How can we end the reserve-currency curse? While acknowledging the complexity of the century-old problem, we must in this article simplify the necessary remedies. The essential requirement for restoring a stable international monetary system is that the major countries agree to replace all official foreign-exchange reserves with an independent monetary asset that is not ultimately some particular nation’s liability. Many standards are theoretically possible, but monetary authorities still hold nearly 900 million ounces of gold, and the simplest, most effective, and most tested solution is a modernized international gold standard.

This would require changes in U.S. law and an international monetary agreement. Ending the dollar’s reserve-currency “privilege,” and its inflationary financing of the federal budget, would make it not only necessary to limit budget deficits — which could no longer be financed by foreign central banks — but also for the first time politically and economically practicable to do so. The reform would halt the proliferation of debt resulting from the current currency system

Neither reforming the international monetary system nor balancing the federal budget could be done without serious national and international discussion. But the technical problems have been long studied and are relatively straightforward. The main action item for President Obama should be to put the reserve-currency addiction on the way to extinction before —not after— its congressional and foreign monetary co-dependents irreparably harm themselves and all the innocents they have heedlessly placed in harm’s way.
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Document 8 [REQUIRED READING!]

DID THE INTERNATIONAL RESERVE CURRENCY SYSTEM CAUSE THE CRISIS? DOOLEY SAYS “NO”. Michael Dooley: “Global imbalances and the crisis: A solution in search of a problem”, VOX, 21 March 2009

In our view, the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy … One “lesson” that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced. The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us …

The idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation. The alternative hypothesis is that an effective deregulation of US markets driven by government-dictated social policy, especially in mortgage origination and packaging, allowed the ever-present incentive to exploit moral hazard to flourish ... Clearly we should enforce prudential regulations that discourage people from acting on such expectations. But do we really want to reform away anything that causes real interest rates to fall and asset prices to rise? … The problem was not financial innovation but the failure of regulators to recognise that innovation generated new ways to exploit moral hazard. Even more, it was the wilful ignorance of policymakers in often overriding the instincts of regulators and financial institutions in order to implement a desired flow of funds to uncreditworthy borrowers.
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Document 9 [NOT REQUIRED READING!]

TWO COMMENTS ON THE GOLD STANDARD REGIME.

(a) Martin Wolf on moral hazard under the gold standard regime: “Under the gold standard, the scale of bail-outs was constrained. In a fiat system, there is no limit, until the value of money collapses”. [Martin Wolf: “Why cautious reform of finance is the risky option”, Financial Times, April 28, 2010]

(b) Karl Polyani on liberalism & the gold standard: “The fount and matrix of the [modern economic and political] system was the self-regulating market. It was this innovation which gave rise to a specific civilization. The gold standard was merely an attempt to extend the domestic market system to the international field; the balance-of-power system was a superstructure erected upon and, partly, worked through the gold standard”. [Cited by Robert Gilpin: “The Nature of Political Economy”, p. 14]
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Document 10 [NOT REQUIRED READING!]

ON THE WASHINGTON AND BEINJING CONSENSUS

(a) Charles Gore: “The Rise and Fall of the Washington Consensus as a Paradigm for Developing Countries”, in C. Roe Goddard, Patrick Cronin & Kishore C. Dash (eds.) International Political Economy, 2nd edition. London: PalgraveMacmillan, 2003, pp. 317-340.

(b) Stefan Harper. The Beijing Consensus, How China’s Authoritarian Model will Dominate the Twenty-First Century. New York: Basic Books 2010, 312 pages. See the review by Gideon Rachman: “The dragon’s deals”, Financial Times, April 24-25 2010.
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Thursday April 29, 2010
IPE Leiden

Agustin Mackinlay

Session 5. Central Banks
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[1] A word on the Greek crisis: Flight-to-quality!

[2] On some issues from Session 4

[3] Central Banks

[4] The Political Economy of China’s economic development model & the international reserve currency (Introduction). We need to read the following article (it is a bit difficult, but we will discuss it in detail, most probably during Session 6) — Michael P. Dooley, David Folkerts-Landau & Peter Garber: “An Essay on the Revived Bretton Woods System”, NBER Working Paper 9971, September 2003.
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The Greek Crisis: Flight-to-Quality!

Change in sovereign 10-year credit spreads: April 22 (Germany 3.08%; Greece 7.83%; spread = 4.75%). April 28 (Germany 2.93%; Greece 10.36%; spread = 7.43%). Note that resources are taken out of Greece (where interest rates go up), and into Germany (where interest rates go down). The very definition of a flight-to-quality episode! [Note: we should also take the entrepreneurs’credit market into account]

From Bloomberg News:

Standard &Poor’s lowered Greece’s credit rating to BB+ from BBB+ and warned that bondholders could recover as little as 30 percent of their initial investment if the country restructures its debt. [SOME INSTITUTIONAL INVESTORS ARE NOT ALLOWED TO HOLD BBB+ RATED DEBT, SO THEY ARE FORCED TO QUIT LENDING TO GREECE!] The downgraded marked the first time a euro member has lost investment grade rating since the currency’s 1999 debut. S&P also reduced Portugal by two steps to A- from A+. German Chancellor Angela Merkel said yesterday she won’t release funds to help Greece shore up its finances until the nation has a “sustainable” plan to reduce its budget deficit. Germany’s Economy Minister Rainer Bruederle said Greece needs to present a plan to overcome its debt crisis as soon as possible.

The yield on the Greek two-year note rose 5.05% to 18.99% yesterday, more than 20 times the comparable German bond and 6 percentage points more than similar-maturity notes from Pakistan. Portugal’s 10-year bond yield jumped 0.41% to 5.724 percent, and Irish 10-year yields surged 0.19% to 5.10 percent. Investors are trying to avoid being caught by the “next Greece,” said Olaf Penninga, who helps manage 140 billion euros ($187 billion) at Robeco Group, an 80-year-old Rotterdam-based asset manager. Portugal plans to raise as much as 25 billion euros this year, equivalent to 15 percent of GDP. That compares with 21 billion euros last year, according to the national debt agency. “As spreads get higher the problems are getting bigger: it’s a self-fulfilling prophecy,” [THIS IS INTERESTING! WHAT DOES HE MEAN BY “SELF-FULFILLING PROPHECY"?] Penninga said in a telephone interview. “It will get more difficult now for Portugal to tap markets.” Robeco reduced exposure to Portuguese bonds last year and sold the last ones in March. The spread on the debt of Italy, the euro region’s third-largest economy, rose 0.30% to 217 points.

[NOW TO SOME “RISK-FREE” ISSUERS] In Japan, 10-year yields to the lowest level in four months, falling 0.025% points to 1.28 percent. “It was absolute carnage,” boosting demand for safer securities such as U.S. Treasuries, Adam Carr, senior economist in Sydney at ICAP Australia Ltd., wrote to clients. The yield on the 10-year slid to 3.67% yesterday, the lowest since March 23 and the biggest drop since Dec. 17. Meanwhile, German bond yield collapsed to 2.93%. “It’s the fear [FEAR!] that Greece or Portugal may affect other areas of Europe and derail this economic recovery,” said Burt White, chief investment officer at LPL Financial in Boston, which oversees $379 billion. “There’s now a perception that we might see Greece or Portugal failing. “People are panicking about the contagion effect,” [PANIC!] said Sydney-based Simon Bonouvrie, who helps manage $1.7 billion at Platypus Asset Management. “It’s an overreaction but the risk aversion will remain until these problems are resolved.”


On some issues from Session 4: The Political Economy of Greed & Fear

. During a flight-to-quality episode, interest rates are mostly determined by the seemingly irrational behavior (fear!) of thousands of individuals who act in panic to protect their capital.

. In such times, interest rates for risky borrowers (entrepreneurs and risky sovereign issuers) increase, while interest rates for “risk-free” issuers decrease. Thus, risk-free sovereign borrowers find themselves in a better position to provide bailout packages to their financial systems, and to fund economic stimulus measures.

. In political economy terms, flight-to-quality episodes of significant magnitude (such as the one triggered by the Lehman Brothers bankruptcy) will affect the interplay between the state and the market, as well as international relations.

. Four elements of the Political Economy of Greed & Fear: [1] Moral hazard; [2]
Womenomics!; [3] the Minsky paradox; [4] International reserve currencies.
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[1] Moral Hazard. Within a country, moral hazard can be loosely defined as the sum of contingent liabilities assumed by the state as a result of the various explicit and implicit safeguards provided to the financial system -- bailout packages, deposit insurance extension, credit guarantees, etc. [See Martin Wolf: “Under the gold standard, the scale of bailouts was constrained. In a fiat system, there is no such limit, until the value of money collapses”, Financial Times, April 28, 2010]. At the international level, moral hazard refers to the incentives of governments to increase public spending, in the knowledge that an IMF-led bailout package will be forthcoming in case of crisis.

The 1994-1995 Mexican crisis provides much material in terms of the political economy of moral hazard. At the domestic level, actions taken by the authorities in 1994 –bailing out several banks– may have induced other banks to take on more risks. At the international level, the 1995 IMF-led bailout package to the Mexican government –brokered by the Clinton administration– may have induced other countries to increase public spending. Eventually, as a result of the 1997-1998 financial crisis, many Asian nations were granted IMF bailout packages. Note that, with the arrival of the new administration in 2001, the United States explicitly withdrew any explicit or implicit commitment to provide bail-out packages to individual countries. US Secretary of the Treasury Paul O’Neill branded Argentina as a leading showcase: no bailout, less moral hazard!
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Documents on moral hazard

Document 1. Ben Bernanke speech March 10, 2009 [The text captures well the incessant tug-of-war inside the minds of policy-makers!]

Too Big to Fail. In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy. However, the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. And it creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support. Moreover, government rescues of too-big-to-fail firms can be costly to taxpayers, as we have seen recently. Indeed, in the present crisis, the too-big-to-fail issue has emerged as an enormous problem. In the midst of this crisis, given the highly fragile state of financial markets and the global economy, government assistance to avoid the failures of major financial institutions has been necessary to avoid a further serious destabilization of the financial system, and our commitment to avoiding such a failure remains firm. Looking to the future, however, it is imperative that policymakers address this issue by better supervising systemically critical firms to prevent excessive risk-taking and by strengthening the resilience of the financial system to minimize the consequences when a large firm must be unwound.
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Document 2. Alan Blinder, January 25 2009 [Against the “moral hazard gods”!]

LETTING LEHMAN GO: The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled —with other financial institutions— to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman.
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Document 3. Joachim Fels, Morgan Stanley, April 16 2010 [Greece & Moral hazard at the international level]

The lesson for other euro area members from the Greek bail-out package is that no matter how badly you violate the SGP guidelines, financial help will be forthcoming, if push comes to shove. This introduces a serious moral hazard problem into the European equation. Fiscal slippage in other countries has now become more rather than less likely. Second, the ECB's climb-down on its collateral rules regarding lower-rated bonds, which ensures that Greek government bonds will still be eligible as collateral in ECB tenders beyond 2010, adds to this moral hazard problem and confirms that the ECB is not immune to political considerations and pressures. Don't get us wrong: It is quite obvious that if Greece had not received a financial backstop package and if the ECB had stuck to its previous pronouncements on the collateral rules, the consequences not only for Greece but the whole euro area financial system and the economy could have been dire. However, the unintended consequence of such action is that it sows the seeds for potentially even bigger problems further down the road.
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Document 4. The New York Times & the Wall Street Journal on Greece & moral hazard

The Wall Street Journal's editorial page takes the view that the imminent aid package to Greece will only exacerbate moral hazard (see "Europe's Bear Stearns"). Note the sharp contrast with the New York Times, who is calling for "a much bigger bailout package" ("Greece and Who’s Next?"). Realism vs. liberalism, anyone?
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[2] Womenomics!

The point that I want to make here, very briefly, is that interest rates in the credit markets result from millions of individual decisions … Institutional factors are important (Session 3), and central banks too. But more and more attention is devoted to the role played by emotions, and how best to manage them.

Some documents

Document 1. J. M. Coates & J. Herbert: “Endogenous steroids and financial risk taking on a London trading floor”, Proceedings of the National Academy of Sciences, April 2008 [Judge Business School, University of Cambridge, Cambridge CB2 1AG, United Kingdom ; Cambridge Center for Brain Repair, University of Cambridge, Cambridge CB2 0PY, United Kingdom]. Edited by Bruce S. McEwen, The Rockefeller University, New York, NY, and approved November 6, 2007 (received for review May 1, 2007)

Abstract. Little is known about the role of the endocrine system in financial risk taking. Here, we report the findings of a study in which we sampled, under real working conditions, endogenous steroids from a group of male traders in the City of London. We found that a trader's morning testosterone level predicts his day's profitability. We also found that a trader's cortisol rises with both the variance of his trading results and the volatility of the market. Our results suggest that higher testosterone may contribute to economic return, whereas cortisol is increased by risk. Our results point to a further possibility: testosterone and cortisol are known to have cognitive and behavioral effects, so if the acutely elevated steroids we observed were to persist or increase as volatility rises, they may shift risk preferences and even affect a trader's ability to engage in rational choice.
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Document 2. Roger Boyes: "Age of Testosterone comes to end in Iceland", TimesOnline (February 7, 2009)

Iceland, ravaged throughout history by volcanic eruptions and natural catastrophes, is struggling with a man-made disaster so overwhelming that the women are taking over. It is, they say here, the end of the Age of Testosterone. Next week a newly minted left-leaning Government led by Johanna Sigurdardottir will start to tackle the tough agenda of cleaning out the old-school-chum networks that have led Iceland to the verge of bankruptcy. Half of her Cabinet will be women; female advisers carrying briefcases move in and out of the Prime Minister's whitewashed office, a former jailhouse in the middle of Reykjavik. Two women, Birna Einarsdottir and Elin Sigfusdottir, now run the struggling and disgraced New Landsbanki and New Glitnir banks. We have to create a new sense of solidarity,” says the Social Democrat Prime Minister. The departing Government — retreating would be more precise — put business first, people second, say the premier's counsellors. Now is the time for a shift in values. Listening to Ms Sigurdardottir talk in her dry, schoolmistress manner, it becomes clear that the fall of the Icelandic Government was not just the first political casualty of the global downturn, but also a signal that men in suits have led the world astray. “We are going to base our economic policies on prudence and responsibility, but we also stress social values, women's rights, equality and justice,” she says. “You can see what is happening,” says Katrin Olafsdottir, Associate Professor of Economics and a member of the board of New Glitnir, which is trying to devise a new mission for the crippled bank. “The men went out there and took these incredibly irrational risks — and getting loads of money for doing it, feeling really good about it - and then the women have to come in to clean it up.”
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Document 3. Renée Adams & Daniel Ferreira: “Women in the Boardroom and Their Impact on Governance and Performance”, October 2008

Abstract. We show that female directors have a significant impact on board inputs and firm outcomes. In a sample of US firms, we find that female directors have better attendance records than male directors, male directors have fewer attendance problems the more gender-diverse the board is, and women are more likely to join monitoring committees. These results suggest that gender-diverse boards allocate more effort to monitoring.
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Some books & articles on emotions, the economy, credit markets:

. Akerlof, George A. & Schiller, Robert A. Animal Spirits. How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism (Princeton University Press, 2009) [see]

. Brassey, Alex. Greed (London: Macmillan, 2009) [see].

. Gasparino, Charles. The Sellout. How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System (New York: HarperBusiness, 2009) [see]. From a Financial Times review: “Gasparino narrates convincingly how banks such as Bear [Stearns] slipped into risking ever more capital, often without the full understanding of their leaders, who were engaged in a contest to see who could catch up with Goldman Sachs”. The same, by the way, could be said about Swiss bank UBS.

. Tett, Gillian: “The emotional markets hypothesis and Greek bonds”, Financial Times, April 10/11 2010.

. Turner Review. A regulatory response to the global banking crisis (London: Financial Services Authority, 2009). See p. 41: “Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings”.
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Some websites about economics & credit markets:

. PIMCO. Perhaps the world’s top credit markets analysts

. Morgan Stanley’s Global Economic Forum.
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INTERESTING, BUT NOT REQUIRED READING ...

- China & globalization. For those of you with an interest on China and globalization, I warmly recommend the work of Thomas P.M. Barnett. Although he is a bit of a maverick, his views are always challenging and interesting. His latest book, which deals extensively with China, is Great Powers. America and the World After Bush (New York: Penguin, 2009) [details]. Dr. Barnett is an indefatigable blogger.

- Greece & moral hazard. The Wall Street Journal's editorial page takes the view that the imminent aid package to Greece will only exacerbate moral hazard (see "Europe's Bear Stearns"). Note the sharp contrast with the New York Times, who is calling for "a much bigger bailout package" ("Greece and Who’s Next?"). Realism vs. liberalism, anyone?

- Two interesting book reviews. (1) Do we need to check the power of deregulated finance? The New York Times's Louis Uchitelle reviews Simon Johnson and James Kwak. 13 Bankers. The Wall Street Takeover and the Next Financial Meltdown (New York: Pantheon Books, 2010); (2) China and the developing world. The Financial Times's Gideon Rachman reviews Stefan Halper. The Beijing Consensus: How China's Authoritarian Model will Dominate the Twenty-First Century (New York: Basic Books, 2010) [see].
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Thursday April 22, 2010
IPE Leiden

Agustin Mackinlay

Session 4. Financial Crisis
________________

Short comments on points raised in Session 3

. Interest rates & microcredit. The reality of very high interest rates unveiled (Neil MacFarquhar: "Banks Making Big Profits From Tiny Loans", The New York Times);

. Microcredit & the problem of scale. Cisco Systems (market capitalization: $155 billion) was established on a very tight budget. But founders Leonard Bosack and Sandra Lerner of Stanford University were able to mortgage their house in order to get the venture off the ground. This stands in sharp contrast to inhabitants of slums in developing economies, who cannot use their assets as collateral to get loans. They are thus forced to rely on credit from a limited number of sources, mostly friends and family.

. Judicial independence: supreme courts & precedents. One element of judicial independence is the role played by precedents as a check on arbitrary legal decisions (stare decisis is the principle according to which precedents are a formal source of law). In countries with high grades in terms of judicial independence, precedents are more important. (a) The Netherlands: “There is no stare decisis in Dutch law, as there is in common law [mostly English-speaking countries], although in practice the Supreme Court will not usually overrule its own previous decisions” (Sanne Taekama, ed. Understanding Dutch Law. Boon Juridische uitgevers, 2004); (b) The European Court of Justice: “Where a question referred to the Court for a preliminary ruling is identical to a question on which the Court has already ruled, where the answer to such question may be clearly deduced from existing case-law or where the answer to the question admits of no reasonable doubt, the Court may, after informing the court or tribunal which referred the question to it, give its decision by reasoned order in which, if appropriate, reference is made to its previous judgment or to the relevant case-law” (Hans Baade: “Stare Decisis in Civil Rights Countries: The Last Bastion”, in Peter Birks & Adrianna Pretto, eds. Themes in Comparative Law. In Honor of Bernard Rudden. Oxford: Oxford University Press, 2002); (c) Jonathan Miller: “Judicial Review and Constitutional Stability: A Sociology of the U.S. Model and Its Collapse in Argentina”, Hastings International and Comparative Law Journal, Vol. 77, No. 21, 1997 [this article discusses, among other things, the frequent changes in Argentina’s Supreme Court jurisprudence].

. On Russia’s “legal nihilism”. Olga Kudeshkina: “Tackling Russia’s Legal Nihilism”, OD Russia, 11 March 2010. See also the Hermitage Capital video.

. A new realism? NYT columnist Tom Friedman wonders whether the need for good governance means that “idealism is the new realism” (“Attention: Baby on Board”, The New York Times, April 13, 2010)

. Bolivia, lithium & the curse of raw materials. “Bolivia can become the Saudi Arabia of lithium”; half of the world’s lithium –needed to power the next generation of hybrid or electric cars– is in Bolivia. But what about the risks related to the performance of contracts? (Simon Romero: “In Bolivia, Untapped Bounty Meets Nationalism”, The New York Times, 2 February 2009)

. Venezuela & “onerous financing costs”. Oil development in the Orinoco Belt is in jeopardy: “Repeated delays in the bidding for rights to exploit the Orinoco Belt reflect investor concerns about political risk, onerous financing costs and the profitability of the projects” (Benedict Mander: “Chávez a problem for oil groups eyeing vast field”, Financial Times). Note that both Venezuela and Iran are usually the most aggressive OPEC member countries when it comes to reduce output …

. Montesquieu in Tehran: fear as the key feature of the government. Shirin Ebadi, winner of the 2003 Nobel Peace Prize, defines the Iranian regime as “ce régime de la peur”. Very interesting! This is exactly how Montesquieu defined despotic government – fear as its very essence. No wonder there is little credit available! (Josyane Savigneau: “Ce régime de la peur réduit les Iraniens au silence”, Le Monde, April 3, 2010).


Financial Crisis & Flight-to-Quality Episodes
The study of the recent financial crisis will greatly help us in our understanding of what is at stake in terms of financial diplomacy. Also, the dynamics of so-called flight-to-quality (or flight-to-safety) episodes will likely feature in the credit market exercise that I am preparing for you! Let me present the issue in two different parts. Part I deals with the specifics of the recent crisis; I trust that by 1:15 PM today you will have forgotten all about them. Part II deals with flight-to-quality episodes and credit markets. I hope will NOT forget this part any time soon!

Part I: Elements of the current financial crisis

. Lehman Brothers, a US broker-dealer, mediates (for a fee, of course) between those who supply loanable resources and those who demand credit. Imagine that the rest of us are US lower-to middle class American citizens ($12,000/year in income) with no property. Lehman Brothers sends out an army of brokers who (for a commission, of course) will offer us mortgages in pretty “generous” terms, both in terms of interest rates and in terms of collateral (100%, or even 120% of the value of the house). The contract are called sub-prime loans. Some contracts are awarded on a 2-28 basis, meaning 2 years at the known current interest rate, and 28 at a variable rate.

. Those mortgages are then collected into a bigger contract, a bond. In turn, many such bonds are bundled into a Collateral Debt Obligation (CDO), an instrument created by Lehman Brothers (for a fee, of course) for its clients. The CDO comprises 3 “tranches”. Tranche 1 absorbs all credit losses from the portfolio during the life of the CDO until they have reached 15% of the total principal. This is risky, because some defaults are to be expected. Tranche 2 absorbs all the losses in excess of 15%, while tranche 3 absorbs the rest (above 30%). Tranche 3 is less risky, because it is deemed highly unlikely that as much as 30% of the underlying bonds will default; it carries a Aaa rating, awarded by rating agencies (for a fee, of course). Thus, the pension fund or hedge fund that buys tranche 3 is supplying loanable resources to the subprime housing market through a high-quality contract made up of a bunch of not-so-good quality contracts!

. In a few years, the CDO market sees phenomenal growth: over $600 billion issued in 2007. That means a massive fee structure for many participants: mortgage brokers (commission), broker-dealers (fee for structuring CDO, up to $15 million each, depending on size), rating agencies (fee for rating the tranches), insurance companies (sellers of insurance policies covering credit risk).

. Sub-prime loans & CDOs: innovation or speculative tool? Alan Greenspan vs. Charles G. Leathers & J. Patrick Raines. Right until 2007, Alan Greenspan is decidedly optimistic about the subprime market: “By 2006, nearly 69% of [American] households owned their own home, up from 64% in 1994 and 44% in 1940. The gains were especially dramatic among Hispanics and blacks, as increasing affluence as well as government encouragement of subprime mortgage programs enabled many members of minority groups to become first-time home buyers” (NOT required reading! Alan Greenspan. The Age of Turbulence. Adventures in a New World. New York: Penguin, 2007, p. 230). The “magic” of financial innovation was such that rich people would be lending to Hispanics and blacks!

. In mid-2007 I discovered this excellent article [NOT required reading!] by Charles G. Leathers & J. Patrick Raines: “The Schumpeterian role of financial innovations in the New Economy's business cycle”, Cambridge Journal of Economics, 2004, No. 28, Vol. 5, pp. 667-681. While Mr. Greenspan reasoned in terms of Schumpeter’s ideas, Leathers & Raines went to the sources and concluded that CDOs and other such instruments were NOT “Schumpeterian” at all. The were not issued to finance innovation (remember Schumpeter’s 5 cases), but rather as instruments created by banks in order to speculate among themselves. Now, that’s what you can call a premonitory article!

. By 2007, CDO issuance had become an industry. More and more people were enticed to take on mortgages on a seemingly more attractive set of conditions. The incentives: fees & commissions! Broker-dealers like Lehman, but also Merrill Lynch and Citigroup were accumulating massive amounts of unsold CDO tranches, sometimes through critical regulatory loopholes. The so-called “bonus culture” appears to have aggravated matters, as investment banks pumped up CDOs …

. The were signs of regulatory loopholes. Lehman Brothers was able to hide as much as $50 billion in assets; these were booked off the balance sheet to avoid mandatory capital requirements against them. See also the recent fraud case filed by the Securities and Exchange Commission (SEC) against Goldman Sachs, for a CDO structure (insured by European investors who took a huge loss) whose underlying bond portfolio was allegedly selected by the same hedge fund that made a $1 billion profit on the insurance contract.

Part II: Flight-to-Quality!

This is the part of today’s session that will retain our attention. Each financial crisis has its own set of specific features, like CDOs in the most recent one. You will soon forget about CDOs. But what’s really important here is that all financial crisis appear to have an element in common: flight-to-quality episodes. And that is worth remembering! Already in his1848 Principles of Political Economy (“Of the Rate of Interest”), John Stuart Mill aptly described what happens in credit markets in all financial crisis:

[REQUIRED READING!]
Fluctuations in the rate of interest arise from variations either in the demand for loans or in the supply. The supply is liable to variation, though less so than the demand. The willingness to lend is greater than usual at the commencement of a period of speculation, and much less than usual during the revulsion which follows. In speculative times, money-lenders as well as other people are inclined to extend their business by stretching their credit; they lend more than usual (just as other classes of dealers and producers employ more than usual) of capital which does not belong to them. Accordingly, these are the times when the rate of interest is low; though for this too (as we shall hereafter see) there are other causes. During the revulsion, on the contrary, interest always rises inordinately, because, while there is a most pressing need on the part of many persons to borrow, there is a general disinclination to lend. This disinclination, when at its extreme point, is called a panic. It occurs when a succession of unexpected failures has created in the mercantile, and sometimes also in the non-mercantile public, a general distrust in each other's solvency; disposing every one not only to refuse fresh credit, except on very onerous terms, but to call in, if possible, all credit which he has already given. Deposits are withdrawn from banks; notes are returned on the issuers in exchange for specie; bankers raise their rate of discount, and withhold their customary advances; merchants refuse to renew mercantile bills.

A “general disinclination to lend”. Indeed!

Let’s look at Lehman’s case in mid-September 2008. Since late 2006, the health of the US housing market had been deteriorating steadily. As defaults started accumulating in 2007, the value of the assets held by Lehman Brothers (notably the more risky CDO tranches) rapidly fell. The extent of the damage was not clear to regulators; fee income seemed to increase, while various accounting techniques enabled the firm to disguise the true situation of its balance sheet. While lending long-term, Lehman was borrowing short-term. Its total debt level had surpassed $600 billion. Some money-market funds (companies that mediate between lenders and borrowers for short-term funds) were lending heavily to Lehman.

When Lehman declared bankruptcy on September 15, one money-market fund that had lent as much as $785 million to Lehman declared that it was unable to pay the full amount of its liabilities. It was the first time that such an event took place! Investors promptly took $40 billion out of that fund. NOW EVERY PARTICIPANT IN THE CREDIT MARKET STARTS TO FEAR ABOUT THE SOLVENCY OF EVERYBODY ELSE!!! WHO HAS LENT TO LEHMAN? WHO HAS LARGE HOLDINGS OF SUBPRIME MORTGAGE DEBT & CDOs? WHO HAS INSURED THOSE WHO HAVE LENT? ETC. ETC. ETC.

This feeling of general distrust sets in motion a flight-to-quality episode in credit markets. Let us see how that works. Imagine one Ms. De Souza, a 37-year old hospital manager in Sao Paulo, Brazil. A mother of two, she wants to send her children to a US college. She needs to very cautious about her $400.000 nest egg! She watches the Lehman news on TV; she reads the newspapers. She starts to worry. “What if my investments in loans to companies both in Brazil and the US decline in value as banks refuse to lend to private companies? What if my investments in loans to emerging market states decline in value as global economic trade and growth falls, forcing some states to default on their debt?” She makes up her mind and calls her broker in Sao Paulo, with three very precise instructions:

1. Cease all lending to entrepreneurs, wherever they are located;
2. Cease all lending to sovereign issuers from emerging markets countries
3. Invest all the available resources into loans to the US Federal government, or to the German government.

The behavior of our hypothetical Ms. De Souza is replicated worldwide. Many investors react exactly like her: in Russia, in Thailand, in the Netherlands, everywhere! Now remember the paper from Horace Brock (Session 2): INTEREST RATES CHANGE WHENEVER NEW INFORMATION ALTERS THE BEHAVIOR OF EITHER/OR THOSE WHO SUPPLY LOANABLE RESOURCES AND THOSE WHO DEMAND CREDIT. The Lehman Brothers bankruptcy IS INDEED NEW INFORMATION! Interest rates are bound to change. But how?

Let us look at two different kinds of credit markets: (a) risk-free credit markets; (b) risky credit markets.

(a) “Risk-free” credit markets. Although no loan can ever be entirely without risk, some sovereign issuers of debt are called “risk-free”. These countries feature: [1] an institutional framework that protects the performance of contracts (rule of law, stable property rights, judicial independence); [2] well-developed credit markets.

(b) Risky credit markets. They include … all the rest! We can divide issuers of risky debt into two categories; (b1) sovereign issuers, mostly emerging-market countries where the performance of contracts carries risk, and where financial markets are underdeveloped; (b2) entrepreneurs, wherever they are located (in both developed and less-developed countries). Unlike sovereign issuers, private companies are unable to impose taxes; their solvency is at risk whenever the economy goes into a prolonged recession.

Note that the definition of “risk-free” is not set in stone. The USA were very risky issuers of debt between 1776 and 1783! Nowadays, some emerging-market countries have made phenomenal progress in terms of property rights protection and credit market sophistication (Brazil, Singapore and South Korea come to mind here).

[DIAGRAMS. WE PLOT CHANGES IN THREE CREDIT MARKETS]

(a) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE ENTREPRENEURS CREDIT MARKET: THE INTEREST RATE GOES UP!

(b) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE CREDIT MARKET FOR RISKY SOVEREIGN BORROWERS: THE INTEREST RATE GOES UP!

(c) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY MORE IN THE CREDIT MARKET FOR RISK-FREE SOVEREIGN BORROWERS: THE INTEREST RATE GOES DOWN!

A FLIGHT-TO-QUALITY EPISODE OCCURS WHENENVER EVENTS (a), (b) and (c) take place.

Credit spreads

Credit spreads are important financial and economic indicators. Credit spreads are simply the difference between two interest rates, one from a risk-free credit market and the other from a risky credit market

. credit spread between entrepreneurs’ and risk-free credit markets. Example. In the USA, the so-called “junk bonds” are credit contracts issued by entrepreneurs (see here). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for entrepreneurs is 7.54% and the interest rate for US Treasury debt is 3.82%, then the credit spread is 7.54% minus 3.82% = 3.72% [Note: these rates change every day, every hour, every minute!]

. credit spread between sovereign emerging market debtors and risk-free credit markets. Example. The average interest rate paid by risky sovereign issuers in emerging markets is currently 6.19% (see). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for risky sovereign emerging markets issuers is 6.19% and the interest rate for US Treasury debt is 3.82%, then the credit spread is 6.19% minus 3.82% = 2.37% [Note: these rates change every day, every hour, every minute!]

DURING A FLIGHT-TO-QUALITY EPISODE, CREDIT SPREADS INCREASE, AS INTEREST RATES IN RISKY CREDIT MARKETS RISE, WHILE INTEREST RATES IN RISK-FREE CREDIT MARKETS DECREASES.

MORE INFORMATION COMING UP SOON...

ON HERNANDO DE SOTO ...

. The key Hernando de Soto reference is his book The Mystery of Capital. Why Capitalism Triumphs in the West and Fails Everywhere Else See (New York: Basic Books, 2000) [chapter 1]. See also his article "The Mystery of Capital", IMF Finance & Develpoment, Vol. 38, No. 1, March 2001.

. De Soto heads the Lima-based ILD think tank.

. See also the volume edited by Robert Home & Hilary Lin. Demystifying the Mystery of Capital: Land Tenure and Poverty in Africa and the Caribbean (London: The GlassHouse Press, 2004).

. While Mr. de Soto admires the many achievements of micro-credit institutions around the world, he is skeptical about their ability to provide entrepreneurs with the scale they need in order to escape poverty.

. By the way, the New York Times has just published a devastating article on the interest rates charged by micro-credit institutions (Neil MacFarquhar: "Banks Making Big Profits From Tiny Loans"). I'll mention it briefly on Thursday.
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SOME ADDITIONAL LINKS (SESSION 3: CREDIT MARKETS & THE RULE OF LAW)

- Links related to governance indicators. The well-known World Bank Governance Indicators can be found at Governance & Anti-Corruption. There are two large-scale surveys of judicial independence: (a) the Fraser Institute's Economic Freedom of the World 2009 Annual Report; (b) the World Economic Forum's table. The "network readiness" indicator is taken from the WEF Global Information Technology Report 2009-2010 [see]. Property rights: this is the link to International Property Rights Index (please note that the IPRI does include some of the previously mentioned variables).

- The Ambrogio Lorenzetti frescoes @ Palazzo Pubblico in Siena. A key feature of tyranny appears to be the complete submission of judicial authority. Magnificent! See Quentin Skinner: "Ambrogio Lorenzetti's Buon Governo frescoes: Two old questions, two new answers", Journal of the Warburg and Courtauld Institutes, LXII, 1999. (More frescoes details here).

- Galiani on interest rates. A great quote from Ferdinando Galiani (1727-1787), a follower of Montesquieu. Galiani writes about interest rates in Della Moneta (1751). He argues that interest rates fell across Europe not because of the abundance of money, but thanks to the effects of moderate government (la dolcezza del governo). Galiani clearly reasons in terms of the supply of loanable resources. Note the comment on the abundance of credit and its impact on poverty. Sadly, I cannot provide a decent translation!

Per render bassi gl'interessi secondo l'esposto di sopra basta evitare il monipolio del danaro, e assicurare la restituzione. Perciò non è stata la sola abbondanza de' metalli preziosi che ha sbassate e quasi estinte le usure da due secoli in qua; ma principalmente la dolcezza del governo quasi in ogni regno goduta. Sieno le liti brevi, la giustizia certa, molta industria ne' popoli, e parsimonia, e saranno tutti i ricchi inclinati a prestare. Là dove è folla di offerenti, non possono esser dure le condizioni dell'offerta. Così saranno i poveri trattati senza crudeltà.

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- Tom Friedman on the "new realism". Is good governance the "new realism"? (Tom Friedman: "Attention: Baby on Board", The New York Times).

- Judicial independence in China (I). Randall Peerenboom specializes in China and the rule of law. He has just edited Judicial Independence in China. Lessons for Global Rule of Law Promotion (New York: Cambridge University Press, 2010 see). From the introduction:

This is the first book in English on judicial independence in China. This may not seem surprising given China remains an effectively single-party socialist authoritarian state, the widely reported prosecutions of political dissidents and the conventional wisdom that China has never had independent courts. On the other hand, this may seem surprising given that China has become a possible model for other developing countries – a model that challenges key assumptions of the multibillion-dollar rule of law promotion industry, including the central importance of judicial independence for all we hold near and dear. Although China's success in achieving economic growth and reducing poverty is well known, less well known is that China outscores the average country in its income class, including many democracies, on many rule of law and good governance indicators, as well as most major indicators of human rights and well-being, with the notable exception of civil and political rights. How has China managed all this without independent courts?

- Judicial independence in China (II). An interesting case of Chinese innovation in the field of ... judicial independence! Liu Li: "Software helps judges mete out sentences", China Daily, July 9, 2006

- Nigeria & the cost of capital. A BBC documentary highlights the case of a talented Lagos entrepreneur (in the gas station business) whose main complaint is the high cost of capital: 25%! By definition, credit depends on confidence and —as Adam Smith put if— on the performance of contracts. Can we trust the performance of contracts when we see scenes like this one?

- On Russia & its political culture. Writing about present-day Russia, Margareta Mommsen and Angelika Nussberger uncover the remnants of Stalinist political culture in matters related to the separation of powers and judicial independence. In the USSR, judicial independence was disdained as bourgeois prejudice. See their book Das System Putin. Gelenkte Demokratie und politische Justiz in Rußland (Beck, 2007) [details].

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Thursday April 15, 2010
IPE Leiden

Agustin Mackinlay

Credit markets & the rule of law
. In 1998, David Landes publishes. The Wealth and Poverty of Nations. Why Some are so Rich and Some so Poor (New York: W.W. Norton). While we will not solve this problem today, we will tackle it from the credit markets perspective

. Consider column [6] in the table. The Netherlands boast the largest bond market in terms of GDP (229%), while Peru ranks the lowest (12%). What is a bond? It is a CONTRACT that specifies the name of the issuer, its size, the way (and the dates) interest rate and principal payments are to be paid. What is GDP? The value of all goods and services produced in a given year.

. If the Netherlands’ GDP amounts to $650 billion, then the size of its bond market is about … $1488.5 billion. (Peru numbers: $250 bn GDP; $30 bn size of bond market). No wonder the Netherlands are considered one of the wealthiest countries on the planet!

. [DIAGRAM]. A stylized presentation of the credit market in the Netherlands and in Peru with a simple supply & demand chart

. No credit, no entrepreneurship (in terms of scale); no entrepreneurship, no innovation; no credit, no infrastructure projects, no development. No credit, no power on the international scene!
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. Let me share some thoughts, numbers and books & articles with you on the issue of the Wealth of Nations from the credit market perspective.

. The first thing to note is that most economics textbooks do not even mention the obvious differences in credit markets across the world. They are mostly published in OECD countries!

. Two recent papers attempt to describe the link between governance indicators and the size of the credit markets: John D. Burger & Francis E. Warnock: “Local Currency Bond Markets”, IMF Staff Papers, Vol. 53, 2006 (especially pp. 141-142); Philip Keefer: “Beyond legal origin and checks and balances: Political credibility, citizen information and financial sector development”, in Stephen Haber, Douglass C. North & Barry Weingast (eds). Political Institutions and Financial Development (Stanford University Press, 2008) [available at Google Books]

. Both papers present econometric models; while very valuable, they provide little information about cause-and-effect relations. My first approach was to tackle the issue from the historical point of view. It turns out that the Netherlands has been at the forefront of financial development since the … XVIIth century! It has always been a low-interest rate country:

In 1665 Sir George Downing, writing in England, pointed out that it was possible for merchants to borrow in Amsterdam at 4 per cent or even 3 per cent, and in 1688 Sir Josiah Child took 3 per cent as normal. Rates of 2 ½ per cent are even mentioned. [NOT required reading! Peter Spufford: “Access to credit and capital in the commercial centres of Europe”, in Karel Davids & Jan Lucassen (eds.) A Miracle Mirrored. The Dutch Republic in European Perspective. Cambridge University Press, 1995, p. 305].

. But how do we account for the Dutch miracle from the credit market perspective? This quote from Dutch historian Ernst Kossmann contains an important clue. In 1675, William III had accepted the sovereignty over Gelderland (where Willaim had led the repulse of the French invasion). The States of Gelderland awarded him the title of Duque (“hertog”):

Even his most unconditional supporters were alarmed; the fury was so great that William felt obliged to refuse the award. In Zeeland he was told by his own supporters that an arbitrary government, the unavoidable consequence of a one-headed system of government –the standard argument of Dutch republicans– would undermine confidence in the commercial and financial institutions of the Republic, which in turn would destroy Dutch prosperity [NOT required reading! E. H. Kossmann. Geschiedenis is als een olifant. Amsterdam: Bert Bakker, 2005, p. 166].


The Montesquieu-Galiani-Smith approach

. French author Montesquieu (1689-1755) is mostly know for his analysis of the English Constitution in The Spirit of the Laws. But he was an economist too. John Maynard Keynes, in the foreword to the French edition of his General Theory, calls Montesquieu “the greatest French economist of all times”. Montesquieu establishes a link between the type of government, interest rates and the size of the credit markets:

[REQUIRED READING!]
Poverty and the uncertainty of fortunes naturalizes usury in despotic states, as each one increases the price of his silver in proportion to the peril involved in lending it. Therefore, destitution is omnipresent in these unhappy countries; there everything is taken away, including the recourse to borrowing (Book V, chapter 15). In moderate states, it is entirely different. Confiscations would render the ownership of goods uncertain; they would despoil innocent children … In these countries of the East, most men have nothing that is secure; there is almost no relation between the present possession of a sum and the expectation of having it back after lending it; therefore, usury increases in proportion to the peril of insolvency (Book XX, chapter 19). These continual changes [in legislation regarding loans in the Roman republic], both by laws and by plebiscites, naturalized usury in Rome, as the creditors who saw in the people their debtor, their legislator, and their judge no longer had trust in contracts (Book XX, chapter 21).

. The Montesquieu hypothesis: DESPOTIC GOVERNMENT = UNCERTAINTY OVER THE PERFORMANCE OF CONTRACTS = SMALL SIZE OF CREDIT MARKETS = POVERTY & USURY!

. [DIAGRAM]. The Montesquieu hypothesis. In despotic governments, the supply of loanable resources is much lower than in moderate regimes.

. TRUST IN THE PERFORMANCE OF CONTRACTS: this is the key to increase the supply of loanable resources! To people living in OECD countries, all of this seems a bit strange; we tend to take the performance of contracts for granted. But look at the two Financial Times articles attached: “Iranians switch to informal savings funds as loans dry up” (March 13) and “Bonds and barter in the sauna” (March 28).

. [DISCUSSION OT TWO FINANCIAL TIMES ARTICLES]

. Russia: contract enforcement, judicial independence & interest rates

(a) The Khodorkovsky affair (Yukos)

THE PERFORMANCE OF CONTRACTS, LADIES & GENTLEMEN!!! What happened to those who supplied credit to Mr. Khodorkovsky? Did their ever recover their money? Not very likely!
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(b) The Shell-Sakhalin-2 scheme. Shell was forced by the Russian government to hand over its controlling stake (55%) in the world's biggest liquefied gas project to something close to 25%. The Anglo-Dutch company was threatened with having its operating licence withdrawn. “In the current situation Shell will not be able to defend its economic interests in a civilised process with the Russian authorities, so they will be obliged to give up control if they want to save at least some adequate part of the project,” said Vladimir Milov, Russia's former deputy energy minister. Bob Amsterdam, the lawyer of the jailed oil oligarch Mikhail Khodorkovsky, said the Kremlin was once again using legal pretexts to cover what was essentially an expropriation of private resources in the energy sector.

THE PERFORMANCE OF CONTRACTS, LADIES & GENTLEMEN!!! Would you lend money to smaller oil companies operating under the radar of Gazprom? If so, at what rate of interest? A low one, or a high one?
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(c) The $250 million Hermitage Capital scandal. Lawyer Sergei Magnitsky found dead in his cell. Says Hermitage Capital’s Bill Browder: “Now, you have a bunch of law enforcement people who are essentially organised criminals with unlimited power to ruin lives, take property and do whatever they like and that's far worse than I have ever seen in Russia before. Russia is essentially a criminal state now.” From an unnamed senior banker in Mosow: “Russia's judicial system is totally compromised. It is strangling entrepreneurship. What happened is a clear impediment for investments coming in, not just for foreing investment but even for local ones”. (Catherine Belton: "Questions remain about Russia tax fraud", Financial Times).

THE PERFORMANCE OF CONTRACTS, LADIES & GENTLEMEN!!! Whatever happened to those who supplied loanable resources to Hermitage Capital companies?

. What we see very clearly (especially in the case of Russia) is the link between concentrated power –and especially the lack of judicial independence– the performance of contracts, and the overall stability of property rights. One of the most important followers of Montesquieu was none other than Scottish philosopher & economist Adam Smith:

[REQUIRED READING!]
When the law does not enforce the performance of contracts, it puts all borrowers nearly upon the same footing with bankrupts or people of doubtful credit in better regulated countries. The uncertainty of recovering his money makes the lender exact the same usurious interest which is usually required from bankrupts. Among the barbarous nations who over-ran the western provinces of the Roman empire, the performance of contracts was left for many ages to the faith of the contracting parties. The courts of justice of their kings seldom intermeddled in it. The high rate of interest which took place in those ancient times may perhaps be partly accounted from this cause. In Bengal, money is frequently lent to farmers at forty, fifty and sixty per cent and the succeeding crop is mortgaged for the payment (Wealth of Nations, Book I, chapter 9).

When the judicial is united to the executive power, it is scarce possible that justice should not frequently be sacrificed to, what is vulgarly called, politics. But upon the impartial administration of justice depends the liberty of every individual, the sense which he has of his own security. In order to make every individual feel himself perfectly secure in the possession of every right which belongs to him, it is not only necessary that the judicial should be separated from the executive power, but that it should be rendered as much as possible independent of that power (Wealth of Nations, Book V, chapter 1).

And that leads us to a more detailed discussion of the table.

. The meaning of governance indicators

From Burger & Warnock (2006): "The importance of institutional and policy settings suggests that even emerging economies have the ability to develop local currency bond markets. Emerging market economies are not predestined to suffer from original sin. To gauge the importance of various factors, our estimates in column 1 of Table 3 imply that (other things being equal) if Brazil had Denmark’s rule of law, its bond market as a share of GDP would be 43 percentage points higher. If Brazil had Denmark’s inflation history, its bond market would be 42 percentage points (of GDP) larger. These amounts are both economically significant—Brazil’s local currency bond market is currently only 22 percent of GDP—and suggest an important role for creditor-friendly policies in emerging markets. The results suggest that the determinants of the size of government and private bond markets are quite similar: Countries with better inflation performance and stronger rule of law have larger sovereign and corporate bond markets".

Think about it! Brazil’s GDP is about $1.27 trillion. Now, 43 percentage points would mean that no less than $546 billion of additional credit that could be made available to entrepreneurs and/or to the government (poverty reduction, etc).

. The ingredients of judicial independence

. Interest rates, wages & human capital risk ( brain drain)

. Political culture, judicial independence and … interest rates (Russia, Latin America)

. Does freedom of the press has anything to do with … credit?

From Philip Keefer (2008): "When average citizens do not believe the promises of political competitors to provide such public goods as secure property rights or are unable to monitor the fulfillment of such promises, financial sector development slows (p. 23). Strong evidence is found for this: the continuous years of competitive elections and newspaper circulation, proxies for the credibility of pre-electoral political promises and voter information, are both significant determinants of financial sector development (p. 35).

. Thomas Friedman: idealism –i.e, good governance– is the new realism (on power) [see]

. Africa

. China & the rule of law

. The sheer complexity of credit markets!

. Micro-credit & property rights

. Why do traditional economics textbooks fail to grasp the differences in credit markets?

. The curse of raw materials: Argentina, Russia, Venezuela, Africa, Bolivia, Canada, Norway

. How to read newspapers!
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