The pyramid principle

Oct 22nd 2009
America’s big banks are getting healthier. The small fry are not Shutterstock

JUDGED by their giant compensation bills, Wall Street’s banks are in fine fettle. But pay is one of the few numbers in their accounts it is easy to make sense of. The investment banks may be booming but they remain black boxes. Both Goldman Sachs and Morgan Stanley, which reported a third-quarter profit of $498m on Wednesday October 21st, continue to take high levels of trading risk.

The accounts of big, troubled banks—in particular Bank of America (BofA) and Citigroup—are awash with exceptional items, including tax gains and changes in the value of their own debt. After adjusting for the funny stuff, those two firms’ common shareholders still made losses in the third quarter. Transparency did at least take a small step forwards at Wells Fargo, America’s fourth-biggest bank by assets and its most taciturn. As well as unveiling a $2.6 billion profit, it announced this week (by press release) that it would start conducting conference calls for investors and stockmarket analysts from January.

Such gripes aside, there is a clear sense that things are improving. The big banks seem to think that the provisioning cycle for bad debts overall is at or near a peak. Meanwhile they are writing up the value of some of the toxic securities whose prices have bounced along with almost every other asset in the known universe. There are still minefields aplenty: the latest Moody’s/REAL commercial-property price index showed another monthly decline, of 3%, in August, and credit cards remain weak for most firms. But the optimism that has prompted bank shares to soar has a foundation. Better still, capital levels are improving as the biggest banks retain their profits, sell assets and exchange debt for common equity.

Still, as a policymaker or a taxpayer, it is hard to view the banking system with anything other than mild nausea. Most of the queasiness stems from the continued accumulation of bumper compensation packages. The Treasury’s pay tsar is thought to be considering imposing deep pay cuts on the 25 most senior executives at firms it still owns shares in, including Citigroup and BofA. But since the bigwigs probably account for under 1% of the total compensation at those banks this would be a largely symbolic move.

The chances of a more severe government response is nevertheless growing. Now the emergency is over, the full horror of a banking system that is too big to fail is becoming ever more apparent. Both Goldman’s and Morgan Stanley’s value-at-risk numbers, a statistical measure of worst-case-scenario losses, remain high. Neither bank’s balance-sheet is shrinking, although they do both have more safe assets like government bonds than a year ago.

At the remaining two big banks with state ownership, things still look very messy. Citigroup has stuck its nastiest bits, including consumer loans and toxic securities, into a separate division, but the hard part lies ahead. At $617 billion this unit’s assets are about a third of Citi’s total, and winding it down will be difficult. At BofA, too, the residual pong of empire-building is hard to ignore. It continues to book more bad debts from Countrywide, a mortgage lender it bought last year.

Yet if the investment banks and the two giant conglomerates present a big regulatory headache, as much concern should focus on those banks further down the scale. In the second quarter of this year America’s banking system overall slipped into the red as bad-debt provisions mounted. There is likely to have been more pain in the third quarter. CreditSights, a research firm, reckons 600 to 1,100 of America’s 8,200 banks may need help from, or winding down by, the Federal Deposit Insurance Corporation, compared with the 118 that have failed since the beginning of 2008.

Right now America’s banking system resembles a pyramid. At the top, two or three firms are doing well. But beneath them are a handful of giant conglomerates that are struggling towards profits, a tier of middling banks with overexposure to risky assets, and a vast base of small banks in deep, deep trouble.

(Source: The Economist print edition, Photo from different source)

Dollar depreciation

Denial or acceptance

Oct 22nd 2009

The dollar’s slide is complicating life for countries with floating exchange rates

IN ONE sense, a weak dollar is good news for the world. Behind the global economy’s current revival is a returning appetite for risky investments, such as equities and corporate bonds. At their most panicky investors shunned all but the safest and most liquid assets: American Treasuries were a favoured comfort blanket. That demand for safe assets prompted a rally in the dollar in the months after the collapse of Lehman Brothers last September.

Now that stockmarkets and economies have bounced back, dollar weakness has returned, causing a headache for countries with floating exchange rates (see chart). That has prompted three responses: direct measures to stop currencies rising; attempts to talk them down; or acceptance of a weak dollar as a fact of life.

Brazil has gone for the direct approach. Foreign capital has flooded in, attracted by the healthy prospects for economic growth and high short-term interest rates. That has pushed up local stock prices, as well as the real, Brazil’s currency. To stem the tide, the government this week reintroduced a tax on foreign purchases of equities and bonds. Though many doubt the long-term efficacy of such measures, it had an immediate effect. The real, which had risen by more than one-third since March, fell by 2% (before regaining some ground). Brazil’s main stockmarket dropped by almost 3%.

Others have resorted to talking their currencies down. In a statement released after its monetary-policy meeting on October 20th, Canada’s central bank said the strength of the Canadian dollar would more than offset all the good news on the economy in the past three months. The currency’s strength would weigh on exports, said the bank’s rate-setters, and mean that inflation would return to its 2% target a bit later than previously forecast. Foreign-exchange markets took the hint: the Canadian dollar fell by 2% against the American one after the bank’s statement.

Europe’s efforts to contain the dollar’s weakness have had rather less impact. This week the dollar slid to $1.50 to the euro, just as Henri Guaino, an adviser to Nicolas Sarkozy, the French president, described such a rate as a “disaster” for Europe’s economy. Mr Sarkozy has often moaned about the harm done to exporters by a muscular euro.

Other euro-zone countries are less rattled. “A strong euro reflects the strength of the European economy,” shrugged Walter Bos, the Dutch finance minister. Germany, Europe’s export powerhouse, feels that its firms can just about live with a euro worth $1.50. Its exporters still flourished when the euro last surged to that level, because demand from Asia and the Middle East for its specialist capital goods proved insensitive to price. France, however, struggled. A report earlier this year by the European Commission showed that French exporters lost market share in the euro’s first decade. Other euro-area countries such as Greece, Ireland, Italy and Spain have at least benefited from the recent revival of risk appetite through lower premiums on their debt.

Even so, there is palpable concern that the dollar’s decline might get out of hand. Jean-Claude Trichet, head of the European Central Bank (ECB), has repeated his line that policymakers across the Atlantic say a strong dollar is in America’s interests. That is meant to signal a shared interest in avoiding a dollar rout. In fact America needs a weak dollar to help revive its economy and reorient it towards exports and away from consumer spending. Since China and some other Asian countries track the dollar, the burden of exchange-rate adjustment falls on the euro. Mr Trichet, Joaquín Almunia, the European Union’s economics commissioner, and Jean-Claude Juncker, who chairs the Eurogroup of finance ministers, will visit China later this year to press for a stronger yuan.

Some think part of the solution is in the gift of the ECB: if it lowered its interest rates it would weaken the euro against the dollar. Yet the monetary-policy setting in the euro area has scarcely been different from that in America. The ECB’s main policy rate, at 1%, is higher than the Federal Reserve’s, but it has been so liberal with its provision of long-term cash loans to banks that excess money has pushed market interest rates close to those of other rich economies. A strong euro may even help by allowing the ECB to maintain a loose monetary stance for longer, says Stephen Jen of BlueGold Capital, a hedge fund.

The ECB will eventually face a problem that some central banks are already encountering. As long as America keeps its interest rates low, attempts by others to tighten policy (even stealthy ones that leave benchmark rates unchanged) are likely to mean a stronger currency. That is a price that Australia’s central bank seems prepared to pay. The minutes of its policy meeting on October 6th, at which it raised its main interest rate, revealed the exchange rate was not a consideration. The bank’s rate-setters ascribed the Australian dollar’s rise to the economy’s resilience and strong commodity prices. In New Zealand, similarly, the central-bank governor, Alan Bollard, told politicians that the kiwi dollar’s strength would not stand in the way of higher rates.

When the global economy was in free fall, all countries looked to stimulate their economies at the same time. “What looked like co-ordination was really coincidence,” says David Woo of Barclays Capital. Recovery is more uneven. Countries with greater exposure to buoyant emerging Asia, such as Australia, are sanguine about a weak greenback. Even Japan seems relatively unfazed. But elsewhere, an ailing dollar feels much more threatening.

From The Economist print edition, Illustration by S. Kambayashi

The Nobel prize for economics

The bigger picture

Oct 12th 2009
From Economist.com

This year’s Nobel prize has rewarded the use of economics to answer wider questions

NEITHER Oliver Williamson of the University of California at Berkeley nor Elinor Ostrom of Indiana University at Bloomington was widely tipped to win this year’s Nobel prize for economics. This may be because their work sits at the boundary of economics, law and political science, and tackles different questions to the ones that economists have traditionally studied. Ms Ostrom is also notable as the first woman to win the economics prize in its 40-year history.

Mr Williamson and Ms Ostrom work independently of each other but both have contributed plenty to economists’ understanding of which institutions—firms, markets, governments, or informal systems of social norms, for example—are best suited for conducting different types of economic transactions. Why, for example, do some transactions take place within firms, while others are carried out in competitive markets?

Ronald Coase, a British economist who won the Nobel prize in 1991, argued that in some situations, and for some kinds of transactions, administrative decision-making within a single legal entity (ie, a company) is more efficient than a straightforward market transaction. Mr Coase’s arguments were influential and convinced economists that the internal workings of organisations were worth paying attention to explicitly. But it was left to Mr Williamson to refine Mr Coase’s theory and clarify what features of certain transactions made carrying them out more efficient within a firm rather than in the market.

Mr Williamson showed that complex transactions involving investment decisions that are much more valuable within a relationship than to a third party are best done within a firm. Part of the problem, he argued, was that some economic transactions are so complicated, and involve so many things which could go wrong, that writing a legally enforceable contract that takes all possibilities into account is impossible. Simpler transactions are completed easily in markets; more complicated ones may demand firms. But in later work he also showed that organising matters within companies had costs: in particular, it relied on internal authority to get things done, and this could be abused.

Ms Ostrom has concentrated on a different aspect of economic governance. She has spent her life studying how human societies manage common resources such as forests, rivers, pastures or wildlife. Just as with public goods, it is difficult to prevent people from using the commons. But unlike public goods, and like private ones, what one person takes leaves less for others. Economic theory then predicts that rational individuals will overuse these resources.

Economists (including Mr Coase) have tended to emphasise property rights as a solution to the problem of managing common resources. Typically that involves either privatisation or putting the resource in government hands. But Ms Ostrom, who is a political scientist by training, spent much of her early career studying how communities managed such common resources. She found that groups of people tended to have complex sets of rules, norms and penalties to ensure that such resources were used sustainably. Such self-governance often worked well.

Successful informal institutions, she found, have certain features in common, which sets them apart from institutions that fail. The principles of game theory, particularly the theory of repeated interactions, proved remarkably useful in formulating general principles of how common resources ought to be managed without necessarily resorting to private or state ownership.

Mr Williamson launched an entire branch of economic theorising which looks more deeply into firms than economists had tended to do previously. His theories have also helped with understanding the choice between equity and debt, and corporate finance more generally. Ms Ostrom’s research has spawned many experiments about how people interact strategically. Some of these have influenced game theory, which originally provided Ms Ostrom with her analytical tools.

The Nobel committee’s decision, like earlier awards to Amartya Sen and Daniel Kahneman, is a welcome shot in the arm for research that crosses disciplinary boundaries in the social sciences.