“Summer” Rerun: Welcome Willem Buiter and Mohamed El-Erian to the Banana Republic Club!

This post first appeared on July 15, 2008

The time has come to announce the formation of the Banana Republic Club. Membership is open, with the sole requirement being that nominees correctly discern behaviors in advanced economies that resemble those of corrupt developing countries, which for sake of convenience are referred to as banana republics. Members are eligible to receive a Carmen Miranda hat, although they are not required to wear it.

Brad DeLong has his Ancient and Hermetic Order of the Shrill. Why should he have all the fun?

We broached this line of thought in a post last year, “America: Banana Republic Watch.” Today we have two well regarded economists pick up the same theme, so it seemed time to commemorate this trend.

Readers are encouraged to nominate other candidates.

Since the US of A is likely to get a disproportionate number of citations, some readers may consider comparing America to, say, Argentina, to be disloyal. We refer them to Frederick Douglass:

A true patriot is a lover of his country who rebukes and does not excuse its sins

Put it another way, if someone is obese, we think we are doing them a favor to tell them that throwing out the scale and getting a fun house skinny mirror is no solution.

Now to the nominees. Willem Buiter adopts a take-no-prisoners stance in his post, “The rescue of Fannie and Freddie by Hankie and Feddie.” Buiter has been a frequent and highly vocal critic of the Fed’s response to the financial crisis (including a less than charitable assessment at a Fed-sponsored conference in New York this May).

But the rescue (if one can call it that, since little concrete has happened) of Fannie and Freddie elicits a new level of scorn:

The bail-out of Fannie Mae and Freddie Mac by the combined forces of the US Treasury and the Federal Reserve Board is the ugliest exercise of its kind I have ever observed outside early transition economies and mature banana republics….

The Treasury has taken another big step on the road to Utter Fiscal Obfuscation. It is doing everything it can to disguise the fact that it is entering in commitments that create potentially massive contingent liabilities for the US tax payer. Even if the purpose served by this increase in contingent liabilities is worth the cost, the manner in which it is done is designed to avoid fiscal accountability. This is as welcome to the Executive as it is to the Congress.

The continuing corruption of the Fed’s mission through its growing use as a quasi-fiscal agent of the US government is deeply worrying. Admittedly, this latest extension of list of eligible counterparties at the primary discount window is small beer when compared to the creation in March 2008 of the off-balance sheet vehicle/SPV in Delaware which houses $30 bn of Bear Stearns’ most toxic assets, all but the first $ 1billion of which represent a contingent exposure of the Fed. If, as I expect will happen, the range of eligible collateral Fannie and Freddie can offer at the discount window is widened in the future, and if the maturity of the loans available to them at the discount window is extended, this latest enhancement of the Fed’s role as a lender of resort will be a further step on the road to the Fed as quasi-fiscal recapitaliser of first resort.

Since 1997, the Fed has long been the least operationally independent central bank in the industrial world. This latest episode suggests its main current purpose is to be an unaccountable quasi-fiscal agent for the US Treasury. If that is correct, the Fed’s capacity to deliver price stability in the future may have been fatally impaired.

Note that the post discussed alternatives for coping with the Freddie/Fannie crisis at some length.

While Buiter enjoys throwing thunderbolts from Olympus, El-Erian, co-president of bond giant Pimco and respected investor and academic who writes from time to time for the Financial Times, typically strives for a cool-headed, analytical tone, and provides sophisticated, nuanced discussions of markets, economic trends, and policies.

However, El-Erian’s previous comment at the Financial Times, a mere week ago, by the standards of his dispassionate style, was positively alarmed, although it did contain a bracing “Fortune favors the brave” speech. This week, in “Crisis and coherence: finance remains vulnerable,” the concern was even more palpable, the mention of opportunity in risk absent, and the comparison to unseemly third-world behavior a noteworthy departure from his normal anodyne stance:

In a few years, we shall look back at this time as one that redefined the landscape of the US financial system and, by association, the workings of global capital markets. The process is inevitably chaotic as it is driven by “crisis management” reactions…. Yet it is possible to make specific predictions.

The financial system is at a crossroads. At current market prices, the system remains under-capitalised despite some $350bn (€220bn, £176bn) of capital-raising over the past 12 months. More over, given the collapse in their equity prices, a growing number of institutions, including such behemoths as Freddie Mac and Fannie Mae, the mortgage agencies, are essentially un able to raise capital without government help. The longer this situation prevails, the higher the risk the financial system will face difficulties in raising other financing critical to day-to-day operations. This would accelerate forced sales of assets into illiquid markets, leading to another downward leg in an already vicious negative spiral.

This realisation drove the recent emergency policy statements from Washington. It is the second time this year that such dramatic announcements were made on a Sunday – a phenomenon historically reserved for developing countries rather than industrial ones. It reflects the understandable eagerness to minimise forced and disorderly deleveraging in a part of the economy that is deeply interlinked with virtually everything else. The financial system is like the oil in your car. Without the oil, it no longer matters whether you have a solid engine, good brakes or fancy safety features. The car will not function….

Accordingly, look for the official sector to encourage further capital-raising and work even harder to isolate the most vulnerable financial institutions and limit the negative spillover effects…

This is a practical approach aimed at striking that delicate balance between laisser-faire and government control. Yet it has important limitations. It does not work for large institutions such as Freddie and Fannie – thus the need for Sunday’s announcement of contingent equity and debt financing from the authorities. Also it cannot handle a large number of institutions facing difficulties. It is likely that additional steps will be needed, lest these limitations end up transforming the current economic and financial dislocations into something even more sinister.

Over the next few months, look for the Federal Reserve to face additional pressure to strengthen the emergency liquidity windows for systemically important institutions. Look for Congress to be asked to appropriate funds to support Freddie and Fannie more directly. Look for innovative mechanisms to raise additional capital for the financial sector through public-private partnerships. And look for other fiscal stimulus measures to counter the increasingly vicious spiral in housing and, soon, consumer demand.

Many of these steps involve distortions to the efficient functioning of markets over the longer term. Implementation is difficult and, in the absence of strong leadership, may not be timely enough. Yet the cost of doing nothing may be even higher. The key is whether all the ad hoc crisis management steps eventually evolve into a coherent and sustainable policy outcome. The jury is still out on this.

In other words, brace yourself for the officialdom making things up as they go along and hope they go to the trouble of cleaning it up later.