IMF, Larry Summers: The Wile E. Coyote Moment Has Arrived

There has been a fair bit of discussion of the so-called Minsky Moment, when an economy that has build a house of cards of speculation and over-leveraged “Ponzi units” (creditor that could never make good on their commitments, and are viable only by finding new suckers to give them new debt to pay old lenders) starts to collapse.

But the idea of a Wile E. Coyote moment is less widely discussed. Wile E. Coyote was the famous Warner Brothers character ever in pursuit of Road Runner. One regular bit of shtick was having him run off cliffs and proceed quite a way in thin air, falling only when he looked down and saw the gulf below him.

A couple of policy makers, like the cartoon coyote, appear to have looked down and suddenly realized that there is not much in the way of support on the way to the bottom.

The Financial Times reports both these stories; they may not get the traction they warrant in the US. The first is the managing director of the IMF hitting the panic button:

The intensifying credit crunch is so severe that lower interest rates alone will not be enough “to get out of the turmoil we are in”, Dominique Strauss-Kahn, the managing director of the International Monetary Fund, warned at the weekend.

In a dramatic volte face for an international body that as recently as the autumn called for “continued fiscal consolidation” in the US, Dominique Strauss-Kahn, the new IMF head, gave a green light for the proposed US fiscal stimulus package and called for other countries to follow suit. “I don’t think we would get rid of the crisis with just monetary tools,” he said, adding “a new fiscal policy is probably today an accurate way to answer the crisis”.

Mr Strauss-Kahn’s words rip apart a long-standing global consensus that fiscal retrenchment in the US and Japan is needed to help reduce huge trade imbalances…..

But amid a sudden enthusiasm for fiscal stimulus packages, some voiced caution. Professor Ken Rogoff of Harvard University and a former chief economist of the IMF said aggressive fiscal easing generates “more harm than good in most cases”, leading to unsustainable budgetary position that require painful correction in the longer term.

Then we have former Treasury secretary Larry Summers calling for a series of measures beyond fiscal stimulus to restore confidence in the markets. While he is directionally correct that more needs to be done, his prescription shows either a lack of understanding or awfully wishful thinking:

There is enormous uncertainty around economic or financial forecasts. It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further as perceptions of declining growth increase credit spreads and risk premiums in financial markets, leading to reduced lending, borrowing and spending exacerbating the pessimism about growth.

Perhaps inevitably given the complexity of the problems, policy measures have seemed ad hoc and reactive: measures to increase bank liquidity one week; to help homeowners avoid foreclosure another; to work towards fiscal stimulus another; to lower interest rates most recently. Confidence would be well served by a comprehensive programme of measures that offers the prospect of accelerating growth and insures against a prolonged downturn. Until that happens, it will be difficult for confidence to return.

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macro-economic stimulus in the US, there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy. This column addresses the first of these imperatives; I will address the remainder in the near future.

Although we can quibble about the efficacy of the measures put in place, so far this is conventional wisdom and most would nod their heads sagely. But then Summers starts to go off the rails:

Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up as Japan’s did in the 1990s.

It is therefore tempting to suggest that paper be aggressively marketed so that prices can be “discovered” and uncertainty resolved. More of this needs to happen. But in the current environment few are looking to increase risk and even fewer are willing to finance increased risk-taking. As a consequence, the prices discovered are likely to be very low and to reflect market conditions more than underlying credit quality. This could trigger cascading liquidations leading to panic.

Proper policy regarding valuing assets and forcing their sale depends on distinguishing between prices that reflect fundamentals and prices that reflect current illiquidity. Good policy is art as much as science, depending as it does on market psychology as well as the underlying realities.

This is an optimistic and probably inaccurate assessment. It regards the main problem as liquidity, that no one wants to make markets right now because conditions are bad (true), price discovery would lead to distressed prices and could generate panic (also true). But he fails to consider that prices might not be all that much higher if the players had adequate balance sheet capacity and good transparency. In other words, the lack of liquidity and transparency issues, while part of the problem, really may not be the big problem. I suspect the real problem will be lack of solvency. There is simply too much debt relative to GDP, and a lot of it will have to be written off.

Assuming that this is a liquidity/ crisis of confidence problem means there might be a tidy way out. But people have been pussyfooting around the notion that this might be a solvency problem. The only case in which it has been addressed is in a very tentative and cosmetic fashion with the New Hope Alliance teaser rate freeze program. Many observers consider it to be a deeply cynical program targeting very few in number, and those who will still pay continue to pay fairly high intro rates (7% ish) on homes with no or negative equity.

If this crisis proves to be mainly a solvency problem, we then face the nasty question of how much do we socialize losses? That gets into questions of both equity (is it fair to the non-deadbeats?) and efficiency (even if it isn’t fair, the alternatives might be worse). No one yet seems willing to engage this line of thinking seriously, Instead, we have badly designed fiscal stimulus programs which are almost certain to reduce our degrees of freedom down the road while failing to ameliorate the situation now.

Back to Summers:

The essential element, if there is to be more transparency in the financial system without a major credit crunch, is increased levels of capital. More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. It is preferable for the economy that banks bolster their capital positions by diluting current owners than by shrinking their lending activities. A critical element of regulatory policy should be insisting on increased capital in existing financial institutions. From this perspective the recent efforts by a number of major financial institutions to raise capital from sovereign wealth funds are constructive. But more will be necessary.

Efforts to infuse capital into existing institutions should be matched by a greater effort to ensure transparent and fair valuations. A capital market where the same loan is valued at one price in a bank, another in a different bank, another in a conduit and yet another as a hedge fund asset to be margined cannot be the basis for sound economic performance.

It is critical that sufficient capital is infused into the bond insurance industry as soon as possible. Their failure or loss of a AAA rating is a potential source of systemic risk. Probably it will be necessary to turn in part to those companies that have a stake in guarantees remaining credible because they have large holdings of guaranteed paper. It appears unlikely that repair will take place without some encouragement and involvement by financial authorities. Though there are many differences and the current problem is more complex, the Long-Term Capital Management work-out is an example of successful public sector involvement.

While attention to date has focused on capital infusions into existing institutions, it would be desirable for capital to be injected into new institutions that do not have the legacy problems of existing ones and can meet the demand for new lending. Warren Buffett’s recent entry into bond insurance is an example. There are grounds for concern about the adequacy of the flow of lending for student loans, automobiles, consumer credit and non-conforming mortgages. In each of these areas, there may be a need for collective private action or for government measures.

This, friankly, is hopelessly confused. More capital is desirable. At this point, that’s a motherhood and apple pie statement. But where is it to come from? This country is already dependent on the kindness of foreign creditors to feed our current account deficit which among other things helps us buy oil. They have been very good about buying stakes in our shaky financial firms, but as we tank the dollar thanks to further rate cuts, which will put those investments underwater independent of how the credit market fare, and as the credit markets get worse (a given as the housing market continues to weaken), their funding is going to come at a higher and higher cost, both in political and financial terms. There is no nice way around this problem but Summers puts far too happy a face on it.

Summers’ “a loan should be priced the same no matter where it lives” is also pretty hopeless. The pricing differences primarily reflect differences in the structures in which the loan resides.

The bond insurer discussion is also, ahem, wishful. Yes, the companies that would benefit from the firms not being downgraded are the logical places to hit up for funding. But those are the same places that two paragraphs above you told to get more capital. You are now telling them to send it out the front door to the bond insurers. The needs of the bond guarantors are urgent, while capital raising takes time, Doing so with a balance sheet you’ve just decided to make worse (particularly if you just told the market you already took all the writedowns you possibly needed to take) is far from a position of strength. How will the sovereign wealth fund who are paying for this in the end react to this?

And then Summers wants capital to go to new institutions to compete with the ones with “legacy problems.” New players will have an insurmountable competitive advantage over incumbents saddled with messes. Most people, yours truly included, regard Buffett’s entry into the bond insurance business as one of the worst things that could have possibly have happened to the current players. Buffett can not only cream off the best business but even charge a premiium because the market knows his AAA is the real deal, but worse, the left-behinds will compete for riskier business, and doubtless compress margins below economically viable levels out of desperation.

If this is an example of good policy thinking, we are serious trouble indeed.