CASE NOT PROVEN

On the day we wake up to the most negative US Federal Reserve base rates ever remembered ('negative' after inflation, about 150bp-350bp less than the rate of inflation depending on how you calculate it) that so reminds us of Japan's response to its crisis of the early '90s (see essays below from much earlier) and as the Bank of England decides whether to drop the base rate by 150bp or more - but not so far that if the US $ now falls a bit sterling won't rise) our news media continues to bellow back-seat driver advice on matters that surely deserve whole academic theses. Lord Lawson says tax cuts are not the solution; it is too late for a Keynesian fiscal boost, best just to drop the UK's 4.5% bank rate. The Daily Telegraph opines that the Bank of England's MPC in the driving seat "but didn't know the Highway Code!" and "Bank of England acted too slowly" to cut interest rates. yet, somewhere we all know these rate cuts are not proportionately passed through to household and corporate borrowing rates. Government is meanwhile using a mix of carrot and stick to tell the banks as firmly as can be done not to accelerate foreclosures. What they do not appreciate is that they are talking to computer systems that are hard, maybe impossible, to readjust to new policy or changing strategy? Human judgment has mostly gone from the heart of traditional banking.
Elsewhere in the forest of crashing newsprint, few articles attracted as many comments in the FT site as Willem Buiter's "Making monetary policy in the UK has become simpler, in no small part thanks to Gordon Brown" (26 October), which proceeds to heap blame on the Prime Minister when he was in charge of the country's finances. Most comments continue in this orduring tone, plus laying additional blame on transatlantic cheap money and Basel II regulation of banks (for being either weakly or ineptly implemented). I agree with the last point and know what I’m talking about in painful detail (I’ve just been looking at a bank were £billions of transactions were not risk-accounted because the accounting system had only a fraction of the headings and data fields required. The failed data was sent to people who no longer worked at the bank and so nothing was done!) A banker and trader called AJGS in the FT from one of the UK clearing banks castigates accountants and risk managers for incompetence. On this, I repeat my view Basel II is conceptually competent and comprehensive, far more so perhaps than we deserve or than banks are capable of digesting; it was only half implemented when crisis struck. The bits that had not been done required economists to become involved. Until a year ago the prevailing fear among top bankers (accountants) was that if they gave way to economists they’d take over the running of the banks. What accountants had not appreciated is that banking was being taken over by mathematicians! Consequently, none, I repeat none, of the major banks succeeded in building adequate economic capital models whereby they could model for economic shocks, which is the hard-core central objective of Basel II regulation! Mathematical risk models now appear discredited and bankers, however fearfully, are forced to give economists their due - maybe?
As for cheap money, between dollar and Euro base rates in a period of subdued consumer price inflation, what choice was there for the sterling? If the UK led in experiencing recession before the EU (current GDP also estimated officially as negative) that is entirely because of how closely tied it is to the USA economy and financial services. When someone called J.L. in the FT site says Gordon Brown “ploughed his own furrow” that is not so; he followed all the prevailing theories of the day (privatisation, central bank so-called ‘independence’, long term non-inflationary growth, whatever was the fashion in the US and among New Keynesians so-called). As for the Euro, the European Commission’s own economists knew in the late '90s it would be a disaster for at least the first five years until 2005 or so, but a similar disaster if they did not do it or postponed doing it, so they decided to proceed in the hope that we'd all learn something and do better after 2006. US and UK recovery after 2001 was faster than expected largely because the Euro zone remained weak (fiscal tightening to squeeze 10 currencies into the Euro toothpaste tube knocked about $500bn off growth and cost 5 million jobs against trend). There was not a sustainable economic argument from the UK’s point of view that joining the Euro would have been good in the medium term. That said, arguments either way only offer marginal benefits net of gains and losses. Gordon took the entirely sensible view that unless there is unquestionably significant benefit for the UK, worthy of all the trouble and cost, there’s no point in joining.
Back to where we are today - whatever the UK did in credit boosting the economy with fast rising house prices, running historically high trade deficits and paying for this by selling mortgage backed securities to foreign investors, was also followed by Ireland, Greece, Spain, Netherlands and others. France and especially Germany shied away from similarly boosting domestic demand hoping instead to rely on export-led growth, which can also be a chimera. The most prudent economy of all by far, however, was Italy with the least expansion of bank credit. This did not stop it from being the first into recession! Case dismissed; Gordon reprieved for lack of compelling evidence?

Gordon Brown's Basel II haircut or hairshirt?

Willem Buiter in the FT (today, 27 October) has issued a long and damning indictment of Gordon brown and of Basel II banking regulation. My equally ex-cathedra response (also posted in the FT) follows:
The Basel II accord did not permit banks to "skimp on capital in exchange for better risk management and market discipline". Basel II has not yet been fully implemented and was only half-way complete by the time the credit crunch struck. Reliance on banks’ internal risk models (something Buiter is angered about) never happened, and in any case all internal models overwhelmingly continued to rely on external ratings agency data. All that internal models could do that marking-to-market could not was risk assess loan collateral and haircuts, and again those tasks use external ratings. One major problem in this was that the external ratings models of CDOs were spectacularly wrong (see blog below "Ratings agencies: the smoking gun" and "protecting Assets like a junk-yard dog" and "B2 or not B2? - another long essay"! Market discipline may be inversely proportional to the degree of euphoria in the market, but Basel II is specifically designed to address this, especially in its Pillar II stress testing and scenario modelling for extreme shocks. It was this aspect that all banks struggled with a failed at. But that was an intellectual as well as a management failure. And the lack of involvement of macro-economists and poverty of academic treatises on the subject are also very much to blame.Basel II did not introduce “vulnerabilities” in what banks knew about risks; they were already there. Basel II and IFRS, when fully implemented, will mean that senior managements of banks cannot be blind-sided on excessive risks - as many have claimed in their hairshirt defence; that they only knew what was in their conventionally audited accounts. No bankers have blamed Basel II for not knowing their true positions!
It is a dilemma to insist on mark-to-market valuations when these depend on ratings agencies errors. Banks and other CDO investors were misled and need time (over the next 5-6 years) to work their way out of current m2m losses in CDOs until actual economic losses are realised, when they will be considerably lesser by about half. Spreading losses over time also reduces those losses and this is what central bank support aims to achieve, to win more time for the banks. Strict mark-to-market principles invite the danger that banks act severely pro-cyclically. Systemic stability may be best served by banks publishing under Basel II Pillar III both m2m and hold-to-maturity values with a strategy for getting from one to the other. There should not be an obstacle in the way of banks taking assets underlying their originated CDOs back on banking book balance sheet, at least the equity and mezzanine tranches. There is no official global relaxation of constraints on bank balance sheet reporting, not yet.
It seems mistaken to blame Gordon Brown as Chancellor of the Exchequer, for encouraging “self-regulation wherever conceivable for banks and other highly leveraged institutions.” That has obviously been led by repeal of Glass-Steagal and other measures including a hands- off de-regulation by SEC and stock exchanges regarding quality of market issues, and decades of tolerance of OTC fixed income markets. Basel II is absolutely not “light-touch regulation” neither does it represent any less than a “strengthening of the global coordination of national financial regulatory regimes”. The cross-border rights of regulators and their coordination and agreement to all sing from the same hymn sheet in risk and accounting standards is clearly defined and operating even as the Basel II edifice is only half-built and only in its first-version implementations. No bank has passed muster in Basel II Pillar I without major issues being spotted by regulators and penalties threatened and imposed including cancelling banking licenses (e.g. Fortis Netherlands). Brown accepted FSA’s membership of C-ebs and opposed EU alignment of tax rates and fiscal stance (via Euro membership), but remained fully aware of the competitive pressures pushing for this as well as good arguments for opposing. A question of optimal balance. Does Willem think all this was wrong? The idea of a regulatory race to the bottom in the face of Sarbanes Oxley, Basel II and IFRS seems much exaggerated. Market euphoria is hard to iron out. In any case a good dose of cyclical experience from time to time is good for the soul of capitalism.
If Brown deemed it advisable to be a devoted disciple of Alan Greenspan, he was in good company and it must have seemed confidence-building politically. But, I am quite unaware of Greenspan having personally diluted Basel II or IFRS or Sarbanes-Oxley, even if he did oppose CDS regulation and trusted too much in the banks. But the banks were not the sole problem. The question of CDS is also the question of unregulated OTC markets and that has a history stretching back long before Greenspan. He flip-flopped less on regulation than Christopher Cox at the SEC, and let’s not forget that market values were for most of Greenspan’s tenure patently cyclical and then still in recovery upturn from 2001 when he vacated his throne. And yes, “Mr. Greenspan, much to his credit, has the intellectual honesty to admit that he was wrong.” Though he is wrong to say, “The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria.“ The fact is, as Moody’s admitted, key historical data was not updated after 2003 by ratings agencies, if we accept that what Moody’s did was true of S&P and Fitch? And, let’s not neglect just how ubiquitous the ratings agencies’ data (and commission services) were and are to the business of commercial as well as investment banking!
Willem says, “The day you hear a political figure say: ‘I am sorry; I made a mistake because I had the wrong understanding of how the world works’ is the day we will be skating in hell on natural ice.” Politicians are in power because they at least know how democratic politics works, what we pay them for. Anything else is up to other professionals like Willem! And we (if I may count in myself with him) have to politically and intellectually win our war of ideas and policy prescriptions. We are mandarins of banking economics. Where are our mea culpas?
Describing Brown’s relentlessly expansionary fiscal policy in New Labour’s second term as”pro-cyclical” is interesting, even Keynesian, but GDP rates were close to or below the so-called long term non-inflationary growth rates. He was wedded to long term stability. The criticism should be that he did not act firmly enough to balance the external account while welcoming FDI inflows bigger than China’s, and certainly should have succeeded better in cooling the property market. But, were there votes in that? Are our intelligent chattering class property investors not also blame-worthy? And, what would have been the media or public response to reviving public sector house-building or raising stamp duty further? In any case, our economy is tied to the US so closely that we are forced to either ride with, or use the lag of 2 quarters to try and actively cushion the UK economy against, the US cycles. Boosting public spending seemed a solution for the latter, one that worked a few years ago at the end of New Labour’s first term picking up on similar deficit spending boosts that Ken Clark employed to climb out of the ‘92 recession and again in ‘95 when growth suddenly faltered (due to severe winter weather in the US and the US budget sign-off crisis), as it was faltering again (led by falling US property prices) leading into the credit crunch of ‘07. The very sound point has been made in the FT by Gillian Tett, that governments have been racing to save the banks in order to try and out-run recession and ensure banks have some part to play in acting counting-cyclically, however marginal compared to what governments will do, and are doing, as the economy’s main counter-cyclical pedalist. In that regard, Gordon Brown’s taking the lead globally has much to be said for it as Willem no doubt agrees. [for more see comment]