(Nearly) nothing to fear but fear itself - World Bank Group

(Nearly) nothing to fear but fear itself - World Bank Group

84 Economics focus (Nearly) nothing to fear but fear itself In a guest article, Olivier Blanchard says that policymakers should focus on reducing unc...

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Economics focus (Nearly) nothing to fear but fear itself In a guest article, Olivier Blanchard says that policymakers should focus on reducing uncertainty

RISES feed uncertainty. And uncertainty affects behaviour, which feeds the crisis. Were a magic C wand to remove uncertainty, the next few quarters

same goes for firms: given the uncertainty, why build a new plant or introduce a new pro duct now? Better to pause until the smoke clears. This is perfectly understandable behaviour on the part of would still be tough (some of the damage cannot be undone), but the crisis would largely go away. consumers and firms—but behaviour which has led to a collapse of demand, a collapse of output and From the Vix index of stockmarket volatility (see chart), to the dispersion of growth forecasts, even to the deep recession we are now in. So what are policymakers to do? First and forethe frequency of the word "uncertain" in the press, most, reduce uncertainty. Do so by removing tail all the indicators of uncertainty are at or near all-time risks, and the perception of tail risks. On the portfohighs. What is at work is not only objective, but also lio side, establish a price, or at least a floor on the subjective uncertainty, or what economists, following Chicago economist Frank Knight's early loth-cen- Olivier Blanchard is the price, of the troubled assets. Ring-fence them or take them off bank balance-sheets. On the contury work, call "Knightian uncertainty". Objective IMF's chief economist sumption side, commit to do whatever it will take uncertainty is about what Donald Rumsfeld (in a different context) referred to as the "known unknowns". Subjective to avoid a Depression, from fiscal stimulus to quantitative easing. uncertainty is about the "unknown unknowns". When, as today, Commit to do more in the future if necessary. Above all, adopt the unknown unknowns dominate, and the economic environ- clear policies and act decisively. Do too much rather than too litment is so complex as to appear nearly incomprehensible, the re- tle. Delays in financial packages have cost a lot already. Further sult is extreme prudence, if not outright paralysis, on the part of rounds of debate will stoke uncertainty and make things worse. Second, undo the effects of uncertainty on the portfolio side, investors, consumers and firms. And this behaviour, in turn, feeds the crisis. and help recycle the funds towards risky assets. The standard adIt affects portfolio decisions. It has led to a dramatic shift away vice here is to return the private financial sector to health through from risky assets to riskless assets, or at least assets perceived as recapitalisation. That is absolutely right, but easier said than riskless. It sometimes looks as if investors around the world only done. And, while damage is slowly repaired, it makes sense for want to hold American Treasury bills. Why? At the start was the states to recycle part of the funds themselves. To caricature: if the realisation that many of the new complex assets were in fact world loves American Treasury bills but the funds would be much riskier than they had seemed. This realisation has now more useful elsewhere, then the government should issue the morphed into a general worry about nearly all risky assets, and bills, and use the proceeds to channel the funds where they are about the balance-sheets of the institutions that hold them. "Bet- needed. It should buy some of the riskier assets, and return some ter safe than sorry" is the motto. Unfortunately, while the motto of these funds back to emerging-market countries to offset capital may make sense for individual investors, it is having catastrophic outflows. This is indeed close to what America's Federal Reserve macroeconomic consequences for the world. It is triggering enor- is now doing with quantitative easing at home and swap lines to mous spreads on risky assets, a credit crunch in advanced econo- foreign central banks. The only difference is that the Fed issues money rather than treasury bills in exchange for its purchases. It mies, and major capital outflows from emerging countries. It affects consumption and investment decisions, and is large- would make more sense for the Treasury to be involved, and to ly behind the dramatic collapse in demand we have observed separate more clearly the role of fiscal and monetary policy, but, over the last three months. Sure, consumers have lost a good part in the current state of play, this is a minor wrinkle. Either will do. of their wealth, and this is reason enough for them to retrench. But there is more at work. If you think that another Depression Retail therapy might be around the corner, better to be careful and save more. Third, undo the effects of the wait-and-see attitudes of consumBetter to wait and see how things turn out. Buying a new house, a ers and firms on the demand side. Get them to spend more, and new car or a new laptop can surely be delayed a few months. The have the state do some of the spending itself Offer incentives to buy now rather than later; for example, temporary subsidies to consumers who turn in a clunker and buy a new car, a measure adopted in France. Increase spending on public infrastructure, a central component of President Barack Obama's programme. Both types of measures are indeed present in the fiscal pro-

► Obama has them in its sights. In testimony released on January 23rd, Timothy Geithner, now America's treasury secretary, said there needed to be more transparency and accountability. In the short term, he suggested imposing centralised clearing—something associated with exchanges—on parts of the market that can be standardised. Days earlier, the Group of Thirty, a panel of world financial experts, spoke of big shortcomings in the infrastructure supporting OTC derivatives. Already, though, the distinction between arc and exchange trading is blurring. As OTC volumes have slumped, efforts to make the markets more "exchange-like" have increased. Many interest-rate swaps and credit-default swaps, now traded OTC, can be standardised. Inertia and brokers' vested interest in protecting their high-margin franchises have kept them off-exchange. Meanwhile, the exchanges are making forays into the OTC area. In January a subsidiary of NASDAQ, an American stock exchange, launched a central clearing house for interest-rate swaps. Its London equivalent, LIFFE, has been granted regulatory approval to offer clearing of credit-default swaps, which provide insurance against default and are especially closely watched by regulators because of the surge of bad debts. Bucking a trend in the finance industry, clearing houses are still hiring staff, such as IT specialists and risk managers. The exchanges say that by offering the flexibility of OTC markets with central clearing and automated processing, they provide the best of both worlds: customisation (within limits) coupled with reduced counterparty and operational risk. Counterparty risk is reduced since all parties work through the same clearing mechanism That leaves less chance of gridlock when a big institution fails. Operational

risks are fewer, because exchanges have been early adopters of automated processing systems, whereas OTC systems are often outdated and time-consuming. Exchanges, finally, produce a plethora of information about prices and markets, a valuable public good. This could mark a reversal of fortune for the OTC market, where trading volumes had grown to almost $700 trillion at

1,1148** A. 181" 83 last count, a ninefold increase in a decade. Yet OTC products have their own blessings; they allow bankers to tailor financial products to their customers' needs. Their relationship with exchanges need not be wholly adversarial. Financial innovations may start out in OTC markets and move to exchanges as they mature. Youth may sometimes be wild, but it should be nurtured, not suppressed. ■

America's mortgage agencies

Government-sponsored anxiety


A source of support for banks when markets first crumbled is causing concern THEY no longer hog the headlines, but 1 America's government-sponsored mortgage agencies, Fannie Mae and Freddie Mac, continue to rack up huge losses. As they wrestle under government "conservatorship", fears are also growing over the health of their corporate cousins, then Federal Home Loan Banks (FHLBS), which have so far survived the credit crunch. Fannie and Freddie, in the red for five consecutive quarters, have said in filings that they could need $5.1. billion of government aid, on top of $14 billion already handed to Freddie. Freddie is in particular trouble, with negative shareholders' equity of $14 billion on September 3oth. This is worse than imagined. The duo could suck up at least $1.2o billion of public cut them any slack. They do not have to abmoney this year, estimates Rajiv Setia of sorb all the market losses because the secuBarclays Capital. At this rate, they will vie rities are classed as "held to maturity". But with American International Group to be- if these impairments are deemed "other come America's biggest money-pit. than temporary", their capital levels could Unlike Fannie and Freddie, the FHLBS be hit hard. The banks argue that they have played a subdued role in the good times. no intention of selling the securities. But When markets dried up, however, they Mr Lockhart says he has been pushing for lent heavily. Advances to their more than "a more rigorous process" in determining 8,000 member banks rose by almost 60%, the depth of the wounds. to roughly $1. trillion (see chart). The list of Mr Lockhart insists that the FHLBS are the biggest recipients is like a who's who of collectively solvent, and analysts agree. the sickly, including Citigroup, Country- Their losses on mortgage securities are unwide and Washington Mutual. likely to exceed 3.0% of their combined capThis business has held up well so far. ital of $57 billion, reckons Mr Setia, which But, although no borrower has defaulted would be painful but manageable. And if on FHLB debt, the risk of this grows as borrowers start to fail en masse, the homemore banks fail. A more immediate worry loan banks will at least be first in line for re-