THE END OF FINANCIAL TRIUMPHALISM?

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

 Will today’s ever widening global financial crisis mark the end of the era of financial triumphalism? Ask a lay person to list the ten great innovations that drive our world today and you probably won’t find too many who mention the Black-Scholes formula for pricing options. But for the financial community, pioneering formulas that paved the way for modern hedging strategies should get just as much credit for the passing period of rapid global growth as cell phones, computers, and the Internet.

Until the last 12 months, finance advocates seemed to have a strong case. By helping to spread risk, high-tech finance could help economies grow faster. Macroeconomists celebrated the “Great Moderation” of the global business cycle, with recessions seeming to become milder and less frequent. And, of course, the financial community was making money hand over fist, creating scores of millionaires and even billionaires worldwide. 

Governments were cheerleaders, too. In anglophone countries, presidents and prime ministers, not to mention some leading central bankers, boasted of superior financial systems that were the envy of the world. When French and German leaders complained that the sprawling and unregulated tentacles of new finance posed huge risks to the global economy, they were derided as sore losers. Small countries such as Iceland decided to get in on the action by privatizing their banks and setting up their own financial centers. If you cannot be Silicon Valley, then why not create a mini-Wall Street?

Now Iceland’s banks, having borrowed several times the national GDP, are in desperate trouble, with debts far beyond what the small country’s taxpayers can absorb. Even the conservative Swiss gave into the temptations of high-tech finance and the riches it promised. Today, the two largest Swiss banks are sinking in liabilities that exceed seven times the country’s income.

Of course, the mother of all bailouts is the absurd blank check the United States government is granting the giant home mortgage lending agencies Fannie Mae and Freddie Mac, which hold or guarantee $5 trillion in mortgages that are looking increasingly dubious. It is ironic indeed that US Treasury Secretary Hank Paulson, a former head of Goldman Sachs, a firm that exemplifies financial triumphalism, is spearheading the effort to save government-sponsored behemoths that have so conspicuously outlived their usefulness.

Advances in the field of finance have potentially had a beneficial impact in raising and smoothing global growth. But there is also a cyclical element to the flowering of finance. When home prices were soaring, the geniuses behind mortgage finance seemed infallible. Now that prices are falling, the genius strategies don’t seem quite so brilliant.

It is an old story. Back in the early 1980’s, financial engineers invented “portfolio insurance,” a fancy active hedging strategy for controlling downside risk. They made piles of money. Unfortunately, when global stock markets crashed in October 1987, the insurance turned out to be useless, mainly because markets for hedging collapsed.

In the late 1990’s, the US hedge fund Long-Term Capital Management convinced the world that its partners were masters of the universe. For a while, it consistently made outsized profits, supposedly due to its Nobel-prize backed financial expertise. In 1998, when LTCM went bust, it became all too clear that the firm was basically making massive quantities of simple bond trades, with huge leverage and huge risk.

For governments, the key to success in regulating financial markets lies in maintaining reasonable constraints during boom times that prevent taxpayer funds from being put excessively at risk. Unfortunately, this is difficult to do, because boom times make people who warn of risks seems like doom mongers. That is why it is so important that governments allow financial firms to fail occasionally. That is the only way to impose real discipline on shareholders, bondholders, and corporate leaders.

Is the current gilded era of financial triumphalism over? There is talk in many countries, even the US, that the time has come to ensure that the entire financial system, including hedge funds and investment banks, become subject to much stricter regulation.

Financial firms are screaming murder, but it is not obvious that broader and better financial regulation would be a bad thing. In my research on the history of international financial crisis with Professor Carmen Reinhart, we find that eras of heavy financial regulation tend to have significantly fewer financial crises than lightly regulated free-wheeling eras, such as those associated with the recent period of financial triumphalism.

No one is suggesting that we go back to the “financial repression” of the 1950’s, but the latest crisis has left little doubt that the entire system for global financial regulation is in serious need of an update. Financial innovation ought to be allowed to flourish, but not without better checks and balances. Otherwise, we will be forever trapped in a framework where taxpayers are forced to bail out banks in bad times, while wealthy shareholders reap huge profits in good times. It is time to leaven financial triumphalism with some humility and common sense.

Source: Project-Syndicate August 2008

A BOND THAT INSURES AGAINST INSTABILITY

Stephany Griffith-Jones is professorial fellow at the Institute of Development Studies and adviser to the United Nations Department of Economic and Social Affairs; Robert Shiller is professor of economics at Yale University and chief economist at MacroMarkets LLC

There has been increasing interest in creating bonds linked to the growth of a countries’ gross domestic product. At the spring meetings of the International Monetary Fund and the World Bank, both potential issuers and investors expressed a clear appetite for such bonds. The servicing of these GDP-linked bonds would be higher in times of rapid growth and lower when grow th was slow or negative.

GDP-linked bonds would have important advantages when compared with conventional debt for borrowers and investors, as well as significant externalities for the international financial system. For borrowers, issuing such bonds would help stabilise public spending throughout the cycle as governments would service more debt when they could better afford to, and less in more difficult times. It would also significantly reduce the likelihood of costly and disruptive defaults and debt crises. Defaulting on debt is a last-resort that governments find highly undesirable and costly to the country’s international reputation. A temporary reduction of a country’s debt service when the economy deteriorates would facilitate more rapid recovery.

For investors, defaults are costly as they result in expensive renegotiation and sometimes in very large losses. As GDP-linked bonds would help reduce the probability of default, effective total payments will tend to be higher than with conventional bonds. Furthermore, GDP-linked bonds would give investors the opportunity of taking a position on a range of countries’ growth rates, offering a valuable diversification opportunity. If GDP-linked bonds became widespread across countries, investors could take a position on growth worldwide – the ultimate risk diversification.

For international institutions, there would be benefits from the decreased likelihood of debt crises. Reduced risk of crisis contagion would also benefit other countries. These externalities and the fact that financial innovations are difficult to introduce may justify some initial public action (for example, from the World Bank) to help develop this market instrument. The World Bank could, for instance, make loans whose servicing would be linked to GDP. The loans could then be grouped, securitised and sold to the financial markets.

GDP-linked bonds should be a core element of government financing both for developed and creditworthy developing countries. Both of these could start today. Developed countries are the best equipped to issue GDP-linked bonds immediately, because of the relatively high trust that is placed in their capital markets and in their GDP accounting. Their doing so would have a valuable demonstration effect around the world.

Developing countries stand to gain more from issuing these bonds and they could start issuing GDP-linked bonds now. The issuance of even small quantities of these bonds by creditworthy emerging economies would help set in motion an important process of financial development.

The history of financial innovation is essentially one of learning by doing. Inflation-indexed bonds met initial scepticism, relating to problems such as precise measurement of inflation. In fact, once these bonds started to be issued, inflation statistics improved further. Inflation-indexed bonds are now widely accepted across the world; in the UK, they represent around a quarter of government debt. A similar evolution can be envisaged for GDP-linked bonds.

Introducing GDP-linked bonds would create a market for the economies themselves. The widespread impression that the stock market of a country is a market for the entire economy is mistaken. Stock markets are claims on net corporate profits that can constitute as little as 10 per cent of GDP.

GDP-linked bonds could take a couple of forms. Simplest is a perpetual bond that pays a share, say a trillionth, of GDP, at regular intervals to the bond holders. Creating such a form would be analogous to listing a country on a market as if it were a stock and would yield the most transparent price discovery. Another form that may be easier to introduce is a conventional bond that pays a coupon tied by a formula to growth rates of GDP, but guarantees a minimum level of debt servicing, even if the economy stops growing.

Whichever way they are created, GDP-indexed bonds would have important advantages for different actors. The moment is particularly favourable. Investor appetite for emerging countries’ risk continues to be strong. Investors’ experience with Argentine GDP-warrants, issued as part of their debt restructuring, has been very positive: their price has been rising significantly. The time seems ideal for one or more creditworthy countries to start issuing GDP-linked bonds and for investors to buy them. Any country whose growth slows significantly would be thankful afterwards that they bought the insurance such bonds represent. Recent instability is showing yet again the value of insurance against economic fluctuations.  Source

PANORAMA OF THE INTERNATIONAL ECONOMY

The Dr. Mauricio Herman (to right) joint to Dr. Rommel Acevedo, General Secretary of WFDFI - World Federation of Development Financing Institutions and of ALIDE,  during his visits our headquarters.

Interviews to Dr. Mauricio Herman, professor of International Economy of the John Hopkins University, of the United States of North America and International Consultant. Dr Herman worked for more than two decades in the Inter-American Development Bank and has been also professor of analysis of projects and development banking in the American University.

October, 2003 

FINANCING FOR THE DEVELOPMENT
FROM A VISION INTERNATIONAL

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Interviews to Dr Andras Uthoff, Coordinator of the Unit of Special Studies of the Economic Commission of United Nations for Latin America and the Caribbean (CEPAL). Dr Uthoff is Commercial Engineer graduated in the University of Chile, and has studies of Doctorate in economics in the University of California, Berkeley, USA. He has made investigations in subjects of poverty, employment and population; saving and finances for the development; capital flows and macroeconomic policy; reform of the systems of pensions; among other subjects.

June, 2003