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
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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.

* * *

- 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!
________

. 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!
_________

(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?
__________

(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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A BRIEF COMMENT ON A POINT RAISED BY FRED ...

AM

During the brief discussion of inflation expectations and central bank independence (April 8), Fred wondered whether a strict adherence to that principle might not lead to a "democratic deficit". Good point! The issue was first raised (to the best of my knowledge) by Werner Bonefeld in his paper on "Europe, the Market and the Transformation of Democracy" (*). According to Mr. Bonefeld, the European Central Bank's independence introduces an element of "mixed government" in Europe. He is of course referring to the Greek notion of mikté — the combined government of the one (monarchy), the few (aristocracy) and the many (democracy) [see Polybius's Histories, Book VI]. Presumably, an independent ECB will act like an aristocratic body. I'm not sure I would agree with such a characterization. And I would ask Mr. Bonefeld: is not inflation an even higher risk? Is not inflation the equivalent of a tax on the poor?

(*) Journal of Contemporary European Studies, Volume 13, Issue 1, April 2005 , pages 93 - 106.

INFLATION EXPECTATIONS & THE CREDIT MARKET: A SIMPLE EXAMPLE

Let me briefly clarify the impact of a change in inflation expectations on long-term interest rates in the credit market.

A key assumption, when people expect a higher inflation rate in the future, is that incomes will rise –at least in nominal terms. If you sell goods or services, your prices will rise (remember: inflation means that all prices go up!). As a worker, you will likely obtain at least a nominal compensation (especially if trade unions are strong). It is precisely this expectation that alters the behavior of those who demand credit. A loan at a fixed rate makes a lot of sense if you expect your income to go up!

Example. If somebody expects his or her nominal income to increase by 15% a year (starting at $10,000), while paying a fixed interest rate of 5% $10,000 for a loan, this is how the interest burden would look like:

[1] Expected nominal income: $10,000 (year 1); $11,500 (year 2); $13,225 (year 3)

[2] Interest payments (fixed!): $500 (year 1); $500 (year 2); $500 (year 3)

[3] Expected interest burden: $500/$10,000 (year 1); $500/$11,500 (year 2); $500/$13,225 (year 3)

In others words, the interest burden is expected to decrease every year, because interest payments remain fixed while your income is expected to go up. This is why –when inflation expectations increase- people demand more credit at each level of the interest rate. In Brock’s diagram, the demand schedule (or curve) moves upward and rightward.

But that may too good to be true!

Those who supply loanable resources will react too! Their situation is precisely the opposite. They expect to receive a fixed interest in a currency that will have less purchasing power. Suppose that the cost of a $100 basket of goods is expected to increase by 15% a year, then this is how the real return to the lender would look like (if he or she lends $10,000 at a fixed 5% rate):

[1] Interest income (fixed!): $500 (year 1); $500 (year 2); $500 (year 3)

[2] Expected cost of a basket of goods: $100 (year 1); $115 (year 2); $132.25 (year 3)

[3] Expected purchasing power of interest income: $500/$100 (year 1); $500/$115 (year 2); $500/$132.25 (year 3)

Thus, I would expect that the purchasing power of my interest income will go down each year. In year 1, my $500 income from loans enables me to “buy” 5 baskets; in year 2, it is expected to buy 4.34 baskets, and only 3.78 baskets in year 3. This is why –when inflation expectations increase– those who supply loanable resources will tend to supply less at each level of the interest rate. In Brock’s diagram, the supply schedule (or curve) moves upward and leftward.

To sum up, whenever inflation expectations increase, interest rates in the credit market will rise, because both those who demand credit and those who supply loanable resources adjust their behavior. More demand for credit and less supply always lead to higher interest rates.
____________

IPE 2010 Leiden University
Session 2 – Agustin Mackinlay
April 8, 2010

An introduction to credit markets
Required reading. Horace W. Brock: “Determinants of interest rates”, in Boris Antl (ed.) Management of Interest Rate Risk (London: Euromoney Publications, 1988).

· The importance of credit markets
· Determinants of interest rates
· Changes in interest rates
____________

The importance of interest rates
We refer here to long-term interest rates (10 years or more); thus, we need to make a distinction between long-term interest rates, which are set on the largely deregulated and globalized credit market, and overnight interbank money-market rates, which are set by central banks. You don’t build a factory, you don’t buy a home on an overnight loan!

Credit, it has been said, is the lifeblood of the modern economy. The capital resources available to entrepreneurs, the cost of the public debt (and therefore future tax levels), the value of our homes –all depend on the availability of credit and on the level of interest rates.
Credit is power! In his biography of the Duke of Marlborough, Winston Churchill marvels at the power of the City of London to “manufacture” credit and win the war against Louis XIV! More recently, Russia faced a severe credit crisis just as it intervened in Georgia –the war lasted barely a week (summer of 2008). US Democratic strategist James Carville famously stated that he wanted to be “reincarnated as the credit [bond] market because it can intimidate everybody”.

Credit & wage levels. Adam Smith and Greece! Countries that face a high cost of labor and –simultaneously–high interest rates (cost of capital) usually are in deep trouble: Argentina 1999-2001, Greece 2010. This has serious implications in terms of financial diplomacy, as the actions that will be taken will depend on the diagnosis…

Determinants of interest rates
Excellent paper by Horace Brock; we only need to “update” it, and to re-introduce politics into the credit market! Note the reference to “loanable resources”: this reminds the reader that lenders risk real resources (savings); in other words, they are not just pushing a button, as central banks do when they change their target for the discount rate.

How interest rates change: whenever new information alters the behavior of either/or those who demand credit and/or those who supply loanable resources.

Changes in interest rates
As we shall see, long-term interest rates can change for a number of reasons (this is another key difference with short-term central bank rates). By far the funniest case I ever encountered about changing interest rates was when Julius Caesar borrowed so much money to pay bribes (to get elected as Pontifex Maximus in 63 BC), that interest rates jumped to 30% in Rome! [Christian Meier. Caesar. A Biography. New York: Basic Books, 1997).

In chapter XXIII (Book III) of his Principles of Political Economy (“Of the Rate of Interest”) [NOT required reading!], John Stuart Mill writes that “Both the demand and supply of loans fluctuate more incessantly than any other demand or supply whatsoever”. Indeed! We will consider the following cases, with more or less intensity: [1] Budget deficits / [2] Inflation expectations / [3] Innovation / [4] Foreigners / [5] Demographics / [6] Rule of law / [7] Flight-to-safety episodes / [8] Islamic finance.

[1] Budget deficits
A useful distinction: demand for credit from the public sector and demand for credit from the private sector. The demand for credit from the public sector deals with the budget deficit (or surplus) and additional financing needs like debt amortization. Remember: when countries face a budget shortfall, they have to borrow!

Recent massive bank bailout-economic recovery packages have swelled most OECD governments’ financing needs. “By the end of this year, OECD sovereign debt will have exploded by nearly 70 per cent from 44 per cent of GDP in 2006 to 71 per cent” (David Roche: “Watch out for sovereign black holes in the credit universe”, Financial Times, April 1, 2010).

Last week the Irish government has announced a bank bailout package that will allow banks to sell €81bn to the National Asset Management Agency, which in turn will issue up to €51bn in bonds. And this week the US Treasury is set to borrow $82 billion from the credit markets.

From Robert E. Rubin & Jacob Weisberg. In an Uncertain World. Tough Choices form Wall Street to Washington. New York: Random House, 2003, pp. 361-363 [NOT required reading!]

When the government borrows, the pool of savings available for private purposes shrinks and the price of capital ―expressed as the interest rate― rises. If the Treasury ceases to borrowing and instead begins paying down some of its outstanding $3.8 trillion debt, the savings pool available to the private sector increases and interest rates go down. A study by Robert Crumby at Georgetown University and two of his colleagues, completed sometime after the hearing, found a strong correlation between bond market interest rates and expectations about future fiscal conditions. The Cumby paper overcame a serious problem with previous papers that had examined only the relationship between interest rates and current fiscal conditions. Focusing instead in the relationship between interest rates and expected future conditions makes sense: a buyer of a five- or ten-year bond should logically be influenced primarily by expectations about interest rates and bond prices over the life of the asset …

Interest rates are affected by many factors, which makes isolating the impact of fiscal conditions more difficult. Also, though fundamentals win out over time, at any given moment the psychology of the market may be at variance with the fundamentals. For example, when the economy and private demand for capital are sluggish, markets may focus very little on unsound long-term fiscal conditions and interest rates may remain low, as happened in 2002 and the first half of 2003. (Although even during that weak period the historically large spread between higher long-term interest rates and the lower short-term rates the Fed controls suggests that the deficits might have been having some effect).

But whatever the effects may be when the economy is weak, once economic conditions are again healthy, the private demand for capital will increase. Then markets will at some point focus on long-term fiscal conditions, and that increase in private demand will then collide with the government demand for financing to fund its budget deficits. Virtually all mainstream economists agree that there is no fiscal free lunch. Though no one can predict when, interest rates will react strongly to expectations of substantial long-term deficits and the effect of those deficits on the demand to borrow.

Let me put numbers on these concepts, to show how powerfully adverse the effects on our economy could be. When used to look at the effects of tax cuts, the Federal Reserve Board model projects that for each increase in the deficit of 1 percent of GDP, long-term interest rates will increase by 0.5 percent to 0.7 percent. Some analysts use lower estimates of that relationship, so, for purposes of this calculation, I assume that if the deficit increases by 1 percent of GDP, long-term interest rates will increase by 0.4 percent.

[2] Inflation expectations
Not the most exciting of topics, I admit. Nonetheless, it is of critical importance. Only if we understand the dynamics of inflation expectations can we pretend to understand the way the Federal Reserve & the ECB work. Inflation expectations are a key element of the dynamics of credit markets and long-term interest rates. The best way to understand this issue is through … a real-life example!

- Scenario: Mexico 1994. Zapatista movement + presidential candidate assassinated + large bank failures. Can we expect the Mexican government to react in panic, printing lots and lots of money?

- Changes in the demand for credit. If so, one would expected to one’s income rise, at least in nominal terms, as prices increase and wages are adjusted upwards. In such a scenario, would you be willing to demand MORE OR LESS CREDIT, AT A FIXED RATE OF INTEREST?

[DIAGRAM: Increasing inflation expectations lead to MORE demand for credit at each level of the interest rate, as increasing income is used to pay fixed interest costs]

- Changes in the supply of loanable resources. If you have funds to lend at a fixed interest rate, the knowledge that you will get paid back in a currency that is worth less (in terms of purchasing power) will make you be willing to supply MORE OR LESS LOANABLE RESOURCES?

[DIAGRAM: Increasing inflation expectations lead to LESS supply of loanable resources at each level of the interest rate, as lenders are paid back in a currency that is worth less in purchasing power terms].

[DIAGRAM: THE NET RESULT. The net result of an increase in inflation expectations is ALWAYS the same: LONG-TERM interest rates go up!!! Note that there is NO INCREASE IN THE AMOUNT OF CREDIT!!!]

The Political Economy of Inflation Expectations: Central Bank independence.
Largely as a result of the 1995 crisis, Mexico embraced the notion of an independent central bank in the second half of the 1990s. There are de jure and de facto measures of Central Bank Independence (CBI); the latter is usually the turnover rate of a central bank governor over a ten-year period.

. No Argentinean central bank governor has ever completed his term! The last sacking took place in February 2010; guess who’s having an inflation problem right now?

. Just after winning the general election in 1997, Tony Blair and Gordon Brown announced that the Bank of England would independently decide over short-term rates; even thought the BoE raised its target for the short-rate from 6.00% to 6.25%, the move triggered a sharp downward adjustment in long-term interest rates. Why?

One could also argue in terms of separation-of-power issues. Following W.B. Gwyn, we can cite three criteria to justify CBI: (a) efficiency; (b) rule of law and; (c) transparency. A central bank that functions as an alter ego of the Treasury department would perhaps be run in a less efficient and transparent way; this situation would also place a great deal of power in the hands of the executive branch. [NOT required reading! W. B. Gwyn. The Meaning of the Separation of Powers. New Orleans: Tulane University, 1965].

The first point was aptly made by Stefan Ingves, gobernor of the Swedish Riksbank [NOT required reading! Stefan Ingves. “The relationship between the Riksbank and the Riksdag”, Bank for International Settlements, June 2007]. For a recent paper with some empirical evidence, see [NOT required reading!] Christopher Crowe & Ellen Meade: “Central Bank Independence and Transparency: Not just cheap talk”, Vox, July 31, 2008. On central bank transparency, see [NOT required reading] Nergiz Dincer & Barry Eichengreen: “Central Bank Transparency: Where, Why and with What Effects?”, NBER Working Paper W13003,2007].

[3] Innovation & credit markets
Now this is an exciting topic! Joseph A. Schumpeter (1883-1950) is the key pioneer in the field of economics and innovation. Schumpeter wrote the Theory of Economic Development [Google Books] in 1911, almost 100 years ago! Schumpeter on the credit market: “He can only become an entrepreneur by previously becoming a debtor … what he first wants is credit” (Theory of Economic Development, p. 102); from a recent biography [NOT required reading! Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007; web; prologue]: “The core ethos of capitalism looks constantly ahead and relies on credit in launching new ventures. From the Latin root credo —'I believe'— credit represents a wager on a better future ... In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations” (p. 7).

Initially, the emergence of innovative entrepreneurs pushes interest rates higher, as demand for credit shifts upward.

[DIAGRAM. Demand for credit increases at each level of the interest rate!]. The result is a higher level of interest rates…

Now, Schumpeter also praised financial innovation — up to a point. In the case of railroads in the second half of the XIXth century, or the automobile industry, he states that “credit creation” in the form of overdrafts and car loans [i.e credit creation on a large scale] made it possible to finance these innovations.

[DIAGRAM. The supply of loanable resources increase]. Note that the net result is a stable interest rate + more credit!!! This is the kind of result you want to have!
But then he adds: “Some of that lending was granted with almost unbelievable freedom and carelessness”. Does that ring a bell? Sounds familiar? BOOM-AND-BUST IS INDEED PART OF THE PACKAGE!!!!. Schumpeter made a distinction between productive & non-productive financial instruments. When bankers create financial instruments to “play amongst themselves”, then the risk of a bubble increases dramatically. But is it possible to really make that distinction?

Alan Greenspan says so. In his 2007 autobiography, Greenspan —a self-declared Schumpeter fan—had only positive things to say about sub-prime lending: “The gains [he is referring to the percentage of households who own their house] 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, pp. 229-230)]

Any ideas? Obviously, Greenspan got that one wrong… On this topic, see [NOT required reading!] the paper 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.
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Innovation & invention
An innovation is an invention with a proven track record in the market place!
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Schumpeter & Keynes (briefly)
Keynes. In times of crisis & depression, when everybody at the same time wants to get out of debt and sell assets, the state has to intervene to counter the downward movement.
Schumpeter. Innovation provides the solution. Innovation itself stimulates demand, as prices tend to drop, which stimulates demand.

Keynes, adds Schumpeter, is too pessimistic about human creativity. As early as 1919 (The Economic Consequences of Peace), he thought that humans had reached the end of their creative potential. Schumpeter was stunned to note that Keynes’ great 1936 book, the General Theory, did not contain one single mention of a firm or an entrepreneur. The Austrian was right on that score.

Keynes. To which Keynes famously responded: “In the long run where all dead”. And here, of course, he was also right.

MINI-DEBATE: Can we have it both ways? Schumpeter for normal times, Keynes for depressions? Both at the same time?
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Assignment No. 2 – March 8, 2010

Find at least one modern example for each of the five types of Schumpeterian innovation (500-word essay)

[Please cite your sources: books, journals, newspapers, company website, website, etc.]. Please cite (only if available) statistics of market size. Please cite innovations, not just inventions. If you think that an invention does have the potential to become an innovation, briefly state the business case!
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[REQUIRED READING!] Excerpt from Joseph A. Schumpeter. The Theory of Economic Development of Innovation (Cambridge, Massachusetts: Harvard University Press, 1934) [1911], p. 66, as quoted by Thomas K. McCraw (*):

Schumpeter specifies five types of innovation that define the entrepreneurial act. To quote his list directly:

(1) The introduction of a new good –that is one with which consumer are not yet familiar- or of a new quality of a good.

(2) The introduction of a new method of production [or commercialization], that is one not yet tested by experience in the branch of manufacture [or retail trade] concerned.

(3) The opening of a new market, that is a market into which the particular branch of manufacture of the country in question has not previously entered, whether or not this market has existed before.

(4) The conquest of a new source of supply of raw materials or half-manufactured goods, again irrespective of whether this source already exists or whether it has first to be created.

(5) The carrying out of the organization of any industry, like the creation of a monopoly position, or the breaking up of [an existing] monopoly position.

(*) Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction(Harvard University Press, 2007).

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Additional documents [NOT required readings!]

Innovators: a touch of madness? (*)

Most innovations are introduced not by the regimented R&D of established corporations, but by scrappy new firms, twin-born with the invention itself. Willian Baumol, who has been laboring for years to create more space for entrepreneurship and innovation in economic theory, ventures that most breakthroughs arise this way ¾ the offspring of independent minds not incumbent companies. Revolution is a risky endeavor. Of 1,091 Canadian inventions surveyed in 2003 by Thomas Astebro, of the University of Toronto, only 75 reached the market. Six of them earned returns of 1,400%, but 45 lost money. A rational manager will balk at such odds. But the entrepreneur answers to his own dreams and demons. Mr. Baumol thinks a “touch of madness” is probably one of the chief qualifications for the job.

(*) The Economist. “Searching for the invisible man”, March 17, 2006.
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Innovators: a bunch a maniacs? (*)

The typical traits of an entrepreneur:

• He is filled with energy.
• He is flooded with ideas.
• He is driven, restless, and unable to keep still.
• He channels his energy into the achievement of wildly grand ambitions.
• He often works on little sleep.
• He feels brilliant, special, chosen, perhaps even destined to change the world.
• He can be euphoric.
• He becomes easily irritated by minor obstacles.
• He is a risk taker.
• He overspends in both his business and personal life.
• He acts out sexually.
• He sometimes acts impulsively, with poor judgment, in ways that can have painful consequences.
• He is fast-talking.
• He is witty and gregarious.
• His confidence can make him charismatic and persuasive.
• He is also prone to making enemies and feels he is persecuted by those who do not accept his vision and mission.

(*) John Gartner. “America’s Manic Entrepreneurs”, The American Enterprise Online, 2005 http://www.taemag.com/issues/articleid.18583/article_detail.asp
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Steve Jobs (*)

Rocketed heavenwards by Toy Story, floated Pixar, became billionaire, rejoined Apple, took credit for predecessor's work, basked in glow, screwed up a bit, realised error of ways, saw potential of music, bought iTunes, produced iPod, survived cancer (so far), basked some more in new glow. Now sitting pretty on intriguing nexus of computers, animated films and digital music. Has ambitions to do something that will be the terror of all mankind, though none shall know what.

(*) Charles Arthur: “Steve Jobs: smoke and mirrors or iCon?”, The Register, May 2005.
http://www.theregister.co.uk/2005/05/20/jobs_biography/

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[NOT required reading!] From Thomas K. McCraw, pp. 476-479:

[Note: McGraw sums up Schumpeter’s sharply critical views about Keynes].

Schumpeter announced the verdict of his intellectual wrestling match [with Keynes] in his presidential address at the annual meeting of the American Economic Association on December 30, 1948, in Cleveland … He knew he was in danger of offending his listeners, most of whom were themselves Keynesians. But he marched fearlessly on. He said that Keynes’s ideological vision, like Marx’s, had been formed quite early. It did not emerge clearly in print until Keynes was thirty-seven years old, at which time the outlines of what became Keynesianism appeared “in a few thoughtful paragraphs in the introduction to the Consequences of the Peace”. Schumpeter asserted that “these paragraphs created modern stagnationism”. They outlined Keynes’s unshakable conviction that the business system was headed toward a state of permanent inanition. In the future, companies would no longer be able to offer good investment opportunities. Funds accumulated by moneyed interests would go unspent. Wages would not be sufficient to support increased consumption. Without government stimulus, capitalism itself would stagnate. “This vision”, said Schumpeter, “never vanished”. It reappeared in many of Keynes’s other works but “was not implemented analytically” until the publication of The General Theory in 1936.

[A word on session 1 April 1]

International Political Economy

Department of Political Science
Leiden University
2010

Course syllabus
Agustin Mackinlay
mackinlaya@fsw.leidenuniv.nl

Part I
Theoretical Approaches in International Political Economy: An Overview
. Session 1. April 1
Assignment. Theoretical Approaches in IPE: Similarities and contrasts (length: 1500 words). Required reading: Goddard & al., chapters 1,2, 12, 13 and 14.
References. C. Roe Goddard, Patrick Cronin & Kishore C. Dash (eds). International Political Economy, 2nd edition (Palgrave Macmillan, 2003).
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Part II
Credit Markets & Central Banks: an introduction
. Session 1: April 1. An Introduction to credit markets.
. Session 2: April 8. Credit markets: budget deficits, innovation, inflation expectations, demographics.
Assignment. Schumpeter and the 5 cases of innovation (length: 500 words)
. Session 3: April 15. Credit markets: property rights & the rule of law; flight-to-quality episodes; Islamic finance.
Exercise. The credit market.
- Session 4: April 22. Central banks: the structure of the Fed and the ECB. Central banks & monetary policy.

References. Horace W. Brock: “Determinants of interest rates”, in Boris Antl (ed.) Management of Interest Rate Risk (London: Euromoney Publications, 1988); Madeleine O. Hosli. The Euro: A Concise Introduction to European Monetary Integration (Boulder, CO: Lynne Rienner, 2005) [chapter 4]; 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). Plus selected passages of Montesquieu and Adam Smith.
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Part III

The Political Economy of China’s Economic Development Strategy & the Global Financial Crisis
. Session 5. April 29. China, the U.S. & Bretton Woods II. International reserve currencies. The global financial crisis of 2007-2009.
Assignment. China’s development strategy and the global financial crisis (length: 500 or 1500 words). Required reading: Dooley, Folkerts-Landau & Garber (2003). Madeleine O. Hosli (chapter 6).

References. Michael P. Dooley, David Folkerts-Landau & Peter Garber: “An Essay on the Revived Bretton Woods System”, NBER Working Paper 9971 (2003); Madeleine O. Hosli. The Euro: A Concise Introduction to European Monetary Integration (Boulder, CO: Lynne Rienner, 2005) [chapter 6]; Robert Mundell: “The Euro: How Important”, Cato Journal, Vol. 18, No. 3 (1999); Charles G. Leathers & J. Patrick Raines: “The Schumpeterian role of financial innovations in the New Economy's business cycle”, Cambridge Journal of Economics, 2004 28 (5): 667-681.
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Part IV

Financial Diplomacy
. Session 6. May 6. The G2, the G8 and the G20: Towards a new international monetary order? The IMF. Soft-balancing: Charles de Gaulle and the ‘deconstruction’ of the dollar.
. Session 7. May 20. Financial Diplomacy & central bank coordination: monetary policy, currency swaps. The euro and the Greek crisis.
Assignment. Recent developments in financial diplomacy (length: 500 or 1500 words). Required readings: Bayne (2008)

References. Nicholas Bayne: “Financial Diplomacy and the Credit Crunch: The Rise of Central Banks”, Journal of International Affairs, Fall / Winter 2008, Vol. 62, No. 1, pp. 1-16; Francis J. Gavin. Gold, Dollars, & Power. The Politics of International Monetary Relations 1958-1971 (The University of Carolina Press, 2004).

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Part V

The Connectivity Approach to International Political Economy
. Session 8. [date to be determined].
Assignment. The Connectivity Approach & ‘Complex Interdependence’ (length: 500 or 1500 words). Required reading: Thomas M.P. Barnett. The Pentagon’s New Map [selected pages]; Goddard & al., chapter 4.

References. Thomas M. P. Barnett: The Pentagon’s New Map. War and Peace in the XXIst Century (New York: Putnam, 2004). Robert O. Keohane & Joseph S. Nye: “Realism and Complex Interdependence”, in C. Roe Goddard, Patrick Cronin & Kishore C. Dash (eds). International Political Economy, 2nd edition. Palgrave Macmillan (2003), chapter 4.

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Grades for this course are calculated on the basis of two 1500-word assignments (20% each), three 500-word assignments and one exercise (12.5% each), and class participation (10%).