Links 5/3/08

'Sex pest' seal attacks penguin BBC

Explaining International Broadband Leadership ITIF. The US continues to fall in international broadband rankings, and non-policy factors explain roughly 3/4 of the slippage.

Holiday from Sanity John Quiggin and My Mayor Blasts the McCain-Clinton Gasoline Tax Holiday PGL. Angry Bear

Fast and Easy Fannie James Hamilton, Econbrowser

Poised for 'Nuclear Deleveraging'? Michael Panzner

Data Centers are Bad For You Paul Kedrosky

Major Arctic sea ice melt is expected this summer PhysOrg. This is so depressing, particularly since I am going to Alaska in August. While this ought to be exciting, the idea of watching a climate disaster is likely to take the fun out of it.

Antidote du jour:

More Experts Disapprove of the Fed's Salvage Operations

Anytime you hear people on different ends of the political spectrum, such as Anna Schwartz (famed as co-author with Milton Friedman) and Harvard's Kenneth Rogoff agree on anything, it's worth taking notice. In this case, it's the Fed's extreme efforts to save the markets, in particular the Bear bailout, that is attracting widespread criticism. One rescue begets further rescue demands, which then lead to rescue expectations, which then leads to undue risk-taking and capital misallocation (code for hidden and explicit costs to the public at large).

Note this Bloomberg article was written before the increase in the Term Auction Facility and broadening of types of acceptable collateral was announced. No doubt that would have elicited even more disapproval.

From Bloomberg:

A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is ``a potential crisis in the student-loan market'' requiring ``similar bold action,'' Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms...

The Fed satisfied Dodd's request today, expanding the swaps to include securities backed by student debt.

``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Critics argue that the result will be to foster greater risk-taking among investors emboldened by the belief that the government will bail them out of bad decisions.

The Fed's loans to Bear Stearns were ``a rogue operation,'' said Anna Schwartz, who co-wrote ``A Monetary History of the United States'' with the late Nobel laureate Milton Friedman.

``To me, it is an open and shut case,'' she said in an interview from her office in New York. ``The Fed had no business intervening there.''

There are already indications that investors perceive the safety net to be widening as a result of the actions by Bernanke, 54, and New York Fed President Timothy Geithner. The Bear Stearns bailout and an emergency facility to loan directly to government bond dealers triggered a decline in measures of credit risk for investment banks and for Fannie Mae, the Washington-based, government-chartered company that is the nation's largest source of funds for home mortgages....

``The market understood that this is the method by which Fannie Mae and Freddie Mac could be bailed out if necessary,'' Poole said....

Geithner defended the loans before the Senate Banking Committee on April 3, saying that the Fed needed to offset risks posed to the entire financial system....

While the Fed must by law withdraw its financing backstop for investment banks once the credit crisis passes, investors will probably still bet on its readiness to intervene.

``There is no way to put the genie back in the bottle,'' Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. ``What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.''

Stern noted that he supported the Fed's moves to restore financial stability....

``It is very hard in the middle of a crisis to know where to draw lines,'' said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. ``They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.''....

The risk to the Fed is that it is routinely asked to step in and support insolvent companies whose creditors are on the run, economists say.

``Discount-window accommodation to insolvent institutions, whether banks or nonbanks, misallocates resources,'' Schwartz said in a 1992 lecture available on the St. Louis Fed Web site. ``Institutions that have failed the market test of viability should not be supported by the Fed's money issues.''

Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. ``The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,'' they wrote. That ``creates a potentially severe moral-hazard problem.''

Whatever regulations and incentives the Fed tries to put in place now would be evaded by the market's innovation of new types of products, Goodfriend said in an interview. Investors would nonetheless still count on the safety net, he added.

``We have to start now to recognize the strategic instability of the path we are on,'' said Goodfriend, now a professor at Carnegie Mellon University's Tepper School of Business in Pittsburgh. The Fed needs to prepare markets for how it won't intervene, which it didn't do before the Bear Stearns meltdown, he said.

The Fed also influenced market incentives when it introduced the so-called Term Securities Lending Facility. The program is designed to lend up to $200 billion of Treasury securities from the Fed's holdings to Wall Street bond dealers in return for commercial and residential mortgage bonds among other collateral. Congress has noticed the program favors mortgage credits, and Dodd asked the Fed to swap some of its $548 billion in Treasury holdings for bonds backed by student loans.

While Bernanke rebuffed Kanjorksi's request for direct loans in a March 31 letter, Fed officials today expanded the collateral they accept under the TSLF. The facility now includes all AAA rated asset-backed investments, including bonds backed by student loans. Former Fed officials say it is risky for the central bank to use its portfolio to address specific markets and satisfy Congress without saying where it will stop.

``If there is a public purpose in lending to investment banks, and taking dodgy mortgage securities as collateral, then it is a question of degree about other potential lending,'' Vincent Reinhart, former director of the Fed board's Division of Monetary Affairs, said in an interview. ``That's the consequence of crossing a line that had been well established for three- quarters of a century.''

More on What Bank of America Might Do With Countrywide Debt

The BofA/Countrywide follies continue. Earlier in the week, the Charlotte bank, in an SEC filing on the pending Countrywide acquisition, remained silent on the question of the fate of Countrywide bonds. As we had mentioned some time ago, BofA plans to use a deal structure that would leave the debt in a subsidiary so that creditors would have recourse only to Countrywide assets, and not BofA resources, for repayment (forgive me if I have oversimplified the structure). However, the Countrywide bonds had nearly doubled in price on the assumption that BofA would assume liability.

Reader Scott forwarded an article from the always-informative Institutional Risk Analytics. It tells us that BofA has agreed to take on Countrywide's $50 billion of Federal Home Loan Bank borrowings. IRA discusses some options for how BofA might proceed, which includes putting Countrywide into Chapter 11.

That begs the question: why didn't Countrywide go bankrupt in the first place? It would have been cleaner for Bank of America to stand aside, wait for Countrywide to crater, and cherry pick the assets it wanted, or buy the whole thing after negotiating a haircut with creditors. That clearly was the best course for shareholders. And Mozilo would not have fared very well in a bankruptcy. It will be harder for the big retail bank to defend its decision to rescue Countrywide if it promptly puts it into bankruptcy.

So despite the claims at the time the deal was announced (that BofA had been keen to buy Countrywide for some time), there was more here than meet the eye.

From Institutional Risk Analytics:

Back in January of this year, we asked whether Bank of America (NYSE:BAC) intends to stand behind the debt holders of Countrywide Financial Corp (NYSE:CFC) when BAC acquires the latter later this year. See our January 22, 2008 comment: "Are Countrywide Financial Bonds Bankruptcy Remote?"

On April 30, 2008, BAC filed a draft form S-4 with the SEC describing the formal terms of the offer to CFC shareholders....

In our earlier comment, we reported that BAC had made no public commitment to the debt holder of CFC. More, we reported that BAC officials, in private discussions with risk officers at other institutions, were explicitly stating that CFC would be kept "bankruptcy remote" from BAC and its affiliates after the close of the acquisition....

The BAC S-4 states: "Bank of America has made no determination in this regard, and there is no assurance that any of such debt would be redeemed, assumed or guaranteed," the company said in a filing with the SEC. The clear implication of BAC's refusal to take responsibility for the $40 billion or so in parent-company debt is that BAC CEO Ken Lewis is considering a bankruptcy filing for CFC as one possible strategy after the transaction closes.

As a banker who spoke to BAC told The IRA back in January: "The BAC strategy is reportedly to manage the orderly liquidation of CFC, excluding Countrywide Bank FSB, and to guarantee payments of interest and principal so long as the remaining non-bank assets and liabilities of CFC support same. The BAC officials reportedly expressed the view that keeping CFC is a separate subsidiary of BAC insulates the rest of the group from legal liabilities and arguably prevents them from ballooning out of control."

At yesterday's close around $6, CFC had a market cap of $3.5 billion and an enterprise value of $70 billion, reflecting the consolidated liabilities of CFC including Countrywide Bank FSB. Once you net out the balance sheet of Countrywide Bank FSB, including the $50 billion or so in FHLB advances due from the $120 billion asset bank, there remains about $40 billion in parent company debt as well as general creditors who stand at risk.

Keep in mind that in terms of liability funding options, the clock is ticking. CFC is already at the limit in terms of FHLB advances, which are set at 50% of the bank unit's ending assets for the prior month. Also, upon the close of the CFC transaction, BAC has committed to repay the FHLB advances at par.

This morning, CFC's short-term debt is currently trading around 92 cents on the dollar....what is the likely recovery value to bond holders of the remaining assets?

Let's imagine for the sake of argument that BAC closes the CFC acquisition, but the US economy and the housing market continue to sink into the mud, forcing prices for mortgage paper, servicing, etc., lower. In that event, BAC may consider a possible "nuclear option" scenario:

First, BAC closes the transaction with CFC, paying the CFC equity holders some nominal amount to win approval of the transaction. CFC is merged into Red Oak Merger Corporation, the de novo shell created for the CFC acquisition. BAC, however, does not take responsibility for Red Oak's liabilities.

Second, BAC acquires Countrywide Bank FSB from Red Oak and moves the bank to another part of the BAC group, contributing an amount equal to the book value of the bank's equity to Red Oak. This reduces the assets and liabilities of Red Oak by about $100 billion, and also weakens any future claim by Red Oak creditors against BAC for fraudulent conveyance in the event of a bankruptcy filing. But acquiring Countrywide Bank FSB, which had $9.4 billion in book equity at year-end 2007, does not significantly improve the overall recovery value for CFC bond holders. Given the generous $7 price for CFC shares as of January, BAC paying well less than book for the bank unit would not be unreasonable.

Third, BAC allows a period of weeks or months to go by, enabling BAC management to get a better sense of the net asset value of Red Oak, including both the liabilities to bond holders and other creditors of Red Oak, as well as other contingent liabilities from litigation and regulatory inquiries, which could be substantial.

Fourth, if BAC determines that the net asset value of Red Oak is far below the value of current and contingent liabilities, then BAC could place Red Oak into Chapter 11, in one fell swoop flushing both the debt holders, general creditors and also the extant litigation and other contingent claims.

There are more than a couple of questions arising from such a "what if" scenario. First and foremost, a bankruptcy filing by an affiliate of BAC might trigger default covenants in all BAC debt and contracts. A filing might also provoke a broader response from investors and regulators, who could construe a bankruptcy filing by Red Oak as a default by the entire BAC group.

But perhaps more troubling, a deliberate strategy to use a "bankruptcy remote" vehicle like Red Oak to insulate BAC from the ongoing value destruction of the subprime meltdown could adversely affect the entire market for bank debt. What investor in their right mind would want to hold the debt of any bank holding company were BAC to elect the nuclear option and place Red Oak into a bankruptcy?

As we wrote bank in January: "More to the point, if the Fed, OCC and OTS are willing to countenance a bank merger transaction where BAC does not explicitly stand behind the parent company debt of CFC, what does this say about the debt of other relatively small bank holding entities such as Washington Mutual (NYSE:WM) and Capital One (NYSE:COF)?"

Now, of course, Ken Lewis and the BAC bankers may be playing chicken with all of us. If the threat of a bankruptcy by Red Oak drives down the secondary market value of the CFC debt, then BAC could buy it back at a discount rather than redeem it at par. If this is BAC's true strategy, then Ken Lewis is playing a very dangerous game indeed.

But how else do you explain BAC's refusal to make an unequivocal statement that they will stand behind the CFC debt? It is BAC's behavior, not the deteriorating financial condition of CFC, which is injecting potentially dangerous instability into this situation. Stay tuned.

If, as we alluded above, the Powers That Be prodded BofA to acquire Countrywide to keep it from failing, and BofA resorts to the strategy outlined above, we will once again find ourselves in the land of unintended consequences.

A Wee Notice to Readers

Dear readers, my flight back from LA was VERY delayed and I am wiped. So I will put a few quick items up tonight and hopefully be back to more-or-less normal early Sunday AM (if you are lucky, I may get make some headway Saturday). And of course, I was stuck in an aluminum cylinder on a big news day (my God, the new TAF?)

Many of you provided comments or e-mails, and I will soldier through them as well.

Hubris, Denial, and the Financial Services Culture

I am still recovering from the Milken Conference, and unlike my fellow blog panelists Paul Kedrosky, Felix Salmon and Mark Thoma, have not written any posts on particular sessions. In part, that was because in my other life as a consultant, I am well aware of the dangers of relying on memory even though mine is pretty good, and I had decided to listen rather than take notes.

But the other reason was in almost all the sessions has a strong element of overt pressure on the speakers to maintain an upbeat tone, combined with repeated reinforcement of Republican/Chicago School of Economics ideology. Normally I would not deem that sort of thing worthy of mention if it were a minor and only occasional element of the program; indeed it would have been valuable if other views had been tolerated and some sparks flew. No, the private sector/deregulation cheerleading was pervasive and baldfaced, and made it hard for me to sort out signal from noise. There were enough cases where I knew the data and knew it to be misrepresented so as to call a lot of what I was hearing into question.

I did manage to see one session that was free of that, by theoretical physicist Lisa Randall talking about her work (needless to say, it was way beyond me, but she did a good job nevertheless), and putting in the lone plea I heard for government intervention. She said the US was losing its edge in her kind of science due to our inability to make commitments that we will adhere to for large scale experiments, like the one at CERN this summer. And she told us it will not make a black hole that will destroy our universe, since the energy involved will be insufficient to produce anything other than a black hole that would dissipate immediately, and the odds of even that were extremely low. But her session had at most 60 in the audience, while the big presentation later on, with Eric Schmidt of Google, Craig Venter (famed for decoding the human genome) and Muhammad Yunus of Grammen Bank, had frequent comments by Venter about how badly the government funded efforts to decode the genome has performed relative to his efforts (with Milken as moderator making supportive noises). Um, isn't it possible that different types and scales of science require different approaches? And no one seemed willing to acknowledge that our vaunted pharmaceutical industry depends heavily on Federal funding (I've seen estimates in the 40% to 55% range).

Mind you, there were some signs of dissent from the Panglossian posturing. Myron Scholes, both in the large lunch ("Four Nobel Prize Winning Economists") on Tuesday and in a panel discussion on innovation in financial services on Wednesday, attempted at several points to take issue with some of the ideas that might have been oversimplified, and met considerable resistance, as did Edmund Phelps, And I noted what care Scholes took to be precise and non-controversial in his presentation. For instance, in the lunch, Milken, who was the moderator, put up a quote from Joseph Stiglitz which said that we were in the worst financial crisis since the Great Depression. Note that Stiglitz isn't alone in making that sort of observation; Soros and various private analysts (and not just Nouriel Roubini). Even the IMF has been unusually outspoken about its concerns.

So what was the response? The economy is not in a recession, unemployment is low, ergo all this talk is off base. Scholes pointed out that we aren't through this yet and in hindsight things might look different, and was almost hooted down (the response was something like, "we are here to try to forecast the future. Looking back is easy."). Similarly, it was Scholes on the second panel who was the ONLY one I heard mention (and only obliquely) the massive facilities the Fed has implemented, and the efforts made by other central banks.

So this group was also a singularly ungrateful lot. Not only was there NO acknowledgment of the magnitude of the efforts made on behalf of the financial services industry, but every time the government was mentioned, it was with derision and elicited considerable applause.

Not that everyone there drank the Kool-Aid, mind you; in fact, the number of like minded might have been quite substantial (during the dinner the second night, the mention of Obama elicited more applause than the other candidates). I had some very good discussions with some others participants despite the impediment of a conference badge that read "Press." One was quite incensed ("Where's the humility?") and later said the fans were turned up high so no one could smell that they were shitting in their pants. Ouch!

But the example that bothered me the most was the panel on financial innovation. The panel consisted of Lewis Ranieri (who created the mortgage backed securities business), Richard Sandor (who invented financial futures), Myron Scholes, and Milken. Some of the lines of thinking were truly peculiar. What was bad about our financial crisis wasn't that is has and will continue for at least the next couple of years to do damage to people's lives and businesses. No, it was that other countries might become skeptical about financial innovation and thus deny themselves the opportunity to use financial innovation to solve problems like climate change and poverty

Ranieri was far and away the most downbeat on the panel, yet was repeatedly steered away from expressing his views fully. He felt that the problems we witnessed are not inherent to the products (ahem, are the bad incentives inherent or not? How do you separate that out?). He pointed out that the economic difference between doing a mod with a borrower who had some ability to pay was 30% (and in context, he seemed to mean 30% of the value of the original mortgage). He acknowledged that the modifications weren't being made, that the industry needed to cut the Gordian knot and might require legislative relief to do so. He also said that things could get very bad (he invoked the Great Depression) if this path wasn't taken. Mind you, that train of thought came out in snippets, with many attempts to steer him away from it. Milken, by contrast, claimed it was another example of highly regulated banks doing stupid things, just like in the sovereign debt crisis of the late 1970s (conveniently forgetting the role Wall Street played in structuring and selling the product, and in repeated and aggressively contacting mortgage orginators and telling them they wanted more product). Milken also maintained that the government should not get involved, the private sector could do a far better job of handling this, again conveniently ignoring the massive subsidies extended by the Fed via negative real interest rates on the short end of the yield curve and an alphabet soup of new facilities. I could go on, but you get the point.

An article earlier this week in the Financial Time by Abigail Hofman focused on the deeply-seated cultural issues that produced the crisis:

I worked for 18 years in investment banking and several aspects of the culture unnerved me. Investment banks are all about making money. At the extreme, this means making money for employees not shareholders. The big revenue producers are revered. It is not considered prudent to upset them by asking too many questions. The subprime meltdown is a perfect example of the "emperor has no clothes" phenomenon. These were complex products, yet obfuscation was considered acceptable. Bank chief executives should have asked more questions. I suspect they saw the juicy profits and hoped underlings understood the risks.

Moreover, investment banking culture has a cult aspect to it. If you work on Wall Street or in the City, you toe the party line. Despite lip-service to "diversity", diversity of thinking is not encouraged. This atmosphere of craven conformity breeds at first complacency and then mistakes.

The Milken conference provided vignettes of how to cultivate conformity: select the likeminded, or at least sympathetic, for high profile roles, and apply subtle and not so subtle pressure to make sure they stay within approved boundaries. But as Hofman's comments suggest, this isn't a Milken conference problem; rather, the conference illustrated certain behaviors found widely in the financial services industry (note also that, at least in my day, most firms were agnostic about their staff's political leanings).

A long time ago at McKinsey, one paradigm they mentioned was that people fell somewhere on the spectrum of internalizers and externalizers. Internalizers tend to blame themselves for what happens whether it was their fault or not. They are very conscientious and strive not to repeat their errors. Externalizers blame everyone else for their problems. They are very resilient and well suited to sales jobs. And they are incapable of learning from their mistakes, since they never make any.

"The inappropriateness of financial regulation"

Because I have yet to throw my stuff back in my bags to be on a morning plane back to NY, I must be brief.

I have not had the chance to think about Avinash Persaud regulatory proposals at VoxEU deeply, but at a first glance, they sound appealing. However, the devil will lie in the details, particularly since all his programs would be new. For instance, he suggests a new axis for distinguishing between lightly and more heavily regulated institutions. While I like the idea, any sharp line will encourage regulatory arbitrage; a gradient might work better. And these proposals are so far from the traditional approach that their novelty alone will provoke resistance.

From VoxEU:

Financial regulation never works the way it should. Here one of the world’s most experienced analysts of the global financial system presents some remarkably clear thinking on why we should not just do more of the same. An alternative model for policy action is proposed.

I have had the misfortune or fortune of being up close and personal with seven major financial crises in my banking career, from the US Savings and Loans crisis of the late 1980s to today’s credit crunch. In each crisis I have observed a “cycle” in the response to the crisis. In the middle of a crisis, when circumstances look dire and chunks of the financial system are falling off, proposals get radical. I recall in December 1992, with the UK and Italy having already been ejected from the European Exchange Rate Mechanism and Spain and Portugal looking vulnerable, some European policy makers flirted with capital controls. But a few months after each crisis is over, these radical plans are tidied away and we are left with three things. And they are always the same three things: better disclosure, prudential controls and risk management.

These measures are the regulatory version of apple pie and ice cream. Who would say no? The thing is – we have been investing heavily in these areas for the past twenty years and do not have much to show for it in terms of financial stability. Over the past eleven years we have had the Asian Financial Crisis, LTCM, the “dotcom bezzle” and now the credit crunch. While more disclosure, controls, and risk management are generally good things and necessary fraud reducing measures, there are few crises I have known from the inside that would not have happened if only there was more disclosure. People knew that sub-prime was a poor risk – it is called sub-prime, after all.

Regulatory shortcomings

The problem is more fundamental, and, unless we address these fundamental issues, we will be condemned to repeat the cycle of boom and bust. Lying close to the heart of the problem in all of these recent crises, from today’s credit crunch to the Savings and Loans debacle and beyond, is the inappropriateness of financial regulation.

My own view of banking regulation would be considered quaint next to today’s practice. I consider the primary objective of intervening in the banking market to be mitigating the substantial systemic consequences of market failure in banking. It is therefore puzzling to me that market prices are now placed at the heart of modern financial regulation, whether in the form of mark-to-market accounting or the market price of risk in risk models. It is not clear to me how we can rely on market prices to protect us from a failure of market prices. I have discussed this before many times so I will focus on the secondary objective, which is to avoid the discouragement of good banking.

A good bank is one that lends to a borrower that other banks would not lend to because of their superior knowledge of the borrower or one that would not lend to a borrower to which everyone lends because of their superior knowledge of the borrower. Modern regulators believe this is too quaint, and, to be fair, many banks were not any good at it. But instead of removing banking licenses from these banks, regulators decided to do away with relationship banking altogether and promoted a switch away from bank finance to market finance where loans are securitised, given public ratings, sold to many investors including other banks, and assessed using approved risk tools that are sensitive to publicly available prices. Now, bankers lend to borrowers that everyone else is lending to, the outcome of a process where the public price of risk is compared with its historic average and a control is applied based on public ratings.

Market finance

This switch to market finance improved “search liquidity” in quiet times. Credit risk that was previously bundled with market and liquidity risk was separated, priced and traded. This has improved the transparency and tradability, but it comes at the expense of systemic liquidity in noisy times.

Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk-models using market prices) that the system will sooner or later send the herd off the cliff edge (Persaud 2000). And no degree of greater sophistication in the modelling of the price of risk will get around this fact. In this world, where falling prices generate more sell-orders from price-sensitive risk models, markets will not be self-stabilising but destabilising and the only way to short-circuit the systemic collapse is for a non-market actor, like some agent of the tax payer, to come in and buy up assets to put a floor under their prices. (I wrote about this liquidity trade-off with some colleagues; Laganá et al. 2006)

Now this is a legitimate model: the marketisation of finance and the resulting improvement in search liquidity in quiet times, coupled with direct state intervention in the crisis. It is the model we have today. But I venture that it is a highly dangerous model. It is expropriation of gains by bankers and socialization of costs by taxpayers. Paying for a decade of bank bonuses can be very expensive for the taxpayer and the opportunities for moral hazard are enormous.

An alternative approach

The alternative model rests on three pillars. The first recognises that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle – it must put it close to the centre. Charles Goodhart and I have proposed contra-cyclical charges – capital charges that rise as the market price of risk falls as measured by financial market prices – and a good starting point for implementation of such charges is the Spanish system of dynamic provisioning (Goodhart and Persaud 2008).

The second pillar focuses regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on out-dated distinctions between banks and non-banks. Institutions without leverage or mismatch should be lightly regulated – if at all – and in particular would not be required to adhere to short term rules such as mark-to-market accounting or market-price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an unlevel playing field, but financial markets are based on diversity, not homogeneity. Incentivising long-term investors to behave long-term will mean that there will be more buyers when banks are forced to sell.

The third pillar is requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out. If such a market could be created, it would not only incentivise good banking and push the focus of regulation away from process to outcomes, but it would provide an incentive for banks to be less systemic. Today, banks have an incentive to be more systemic as a bail out is then guaranteed. The right response to Citibank’s routine failure to anticipate its credit risks is not for it to keep on getting bigger so that it can remain too big to fail, but for it to whither away under rising insurance premiums paid to tax payers.

Links 5/2/08

'Big Dry' hits Australian farmers BBC

J.K. Rowling, Lexicon and Oz Orson Scott Card

Insight: Triple A prices are out of sync Gillian Tett, Financial Times

Mortgage Aid Plan Advances in House New York Times

Risk taking, remuneration and leverage Willem Buiter. Or "What we lost by abolisihing debtors' prison."

U.S. Recession Probabilities Jeremy Piger (hat tip Mark Thoma)

Barron's Panic Euphoria Model Barry Ritholtz

Party of Denial Paul Krugman

Antidote du jour:

Bank of America May Not Guarantee Countrywide Debt

Some months ago, we had mentioned that Bank of America was keen to avoid taking on Countrywide's liabilities (who wouldn't be?). The possibility that the giant bank might not provide a guarantee for Countrywide's debt came to the fore again. Without BofA backing, the Countrywide paper is a pretty dodgy proposition. From Bloomberg:

Bank of America Corp., the second- biggest U.S. bank, said it may not guarantee $38.1 billion of Countrywide Financial Corp.'s debt after taking over the mortgage lender, fueling speculation that Countrywide's bondholders face renewed risk of default.

``There is no assurance that any such debt would be redeemed, assumed or guaranteed,'' the Charlotte, North Carolina- based bank said in an April 30 regulatory filing, adding that no decision has been reached....

Countrywide's $1 billion of 6.25 percent notes maturing in 2016 traded at 90.25 cents on the dollar yesterday with a yield of about 7.9 percent, according to Bloomberg data. The debt traded as low as 46 cents in January, with a yield of 20 percent, just before Bank of America announced the purchase.

``I'd be quite concerned if I was a bondholder if the intent of Bank of America is as it reads in the filing,'' said Gary Austin, founder of PDR Advisors LLC, an investment management firm in Charlotte. His firm, which manages about $600 million, doesn't hold Countrywide debt...

``This confirms how tenuous this transaction is,'' said Christopher Whalen, managing director at Institutional Risk Analytics, a banking research firm, from Torrance, California....

The wording in the bank's filing is new, Victoria Wagner, a credit analyst at Standard & Poor's Corp., said in an interview yesterday.

``If they let the debt fail, it would have implications for their other obligations,'' she said. ``They are still going to wholly own Countrywide.''.

"Four mega-dangers international financial markets face"

"Mega" is not the sort of word one usually associates with economic analysis. It's the domain of popular books and obesity-inducing sizes of junk food.

The normally sober blog VoxEU may be drifting into pop economics usage, although the focus of its article is straightforward. Dennis J Snower argues that the credit crisis, and more important, its knock-on effects, are still playing themselves out, and will continue to do so for some time. By implication, it's premature to declare the stress over or even near an end, and the downside could be considerably worse than most observers believe.

From Vox EU:

The financial turmoil has been worsening as lagged adjustment processes play out. This column outlines economic dangers that may arise as they unwind, including a scenario in which the United States suffers extended stagflation.

Day after day new, alarming news emerges from the world’s financial markets, and day after day the public is surprised by how bad it is....

I suggest that our repeated surprise should be more surprising. This issue is important, because if we were better at recognising the financial risks we face, we could do more to avoid them. If banks, investment houses, and American homeowners had done a better job in recognising the risks in the subprime mortgage market, we could have spared ourselves the current crisis.

Why does the public repeatedly underestimate the repercussions of the present financial crisis? The answer is simple: most of us are short-sighted; we can’t imagine a future that is radically different from the present. In particular, most of us don’t understand that economic events often unfold gradually due to the operation of important lagged adjustment processes embedded in the economy. The public, the media and politicians would do well to give them close attention. Lagged adjustment processes. After the Titanic’s hull was punctured, it took hours for its hull to fill with water; thus the passengers couldn’t imagine that it would sink.

In my judgment, there are currently four major dangers facing the world economy, and all of them are currently obscured by the fact they play themselves out slowly.

Four dangers
The first danger we have witnessed since August 2007: The subprime mortgage crisis gave rise to a liquidity crisis in the international banking system, due to uncertainty about who holds the losses. This is leading to reduced lending to firms and households. But that is not the end of the story, because the reduced lending will lead to reduced consumption and investment. With a lag, reduced sales of goods and services will reduce stock market valuations. And, with another lag, the lower stock market prices will – in the absence of any favourable fortuitous events – intensify the banks’ liquidity crisis.

The second danger lies in the dynamics of U.S. house prices. As more and more U.S. households find themselves unable to repay their mortgages, foreclosures are on the rise, more houses are put on the market, the price of houses falls further – with further lags – this leads to more foreclosures and declines in housing wealth. This dynamic process plays itself out only gradually, as households face progressively more stringent credit conditions and house sales gradually lead to lower house prices.

The third danger results from the interaction between wealth, spending and employment. As U.S. households’ wealth – in the housing market and the stock market – falls, their consumption is beginning to fall and will continue to do so, again with a lag. This decline in consumption is leading to a decline in profits, of which more is on the way, which in turn will lead to a decline in investment. The combined decline in consumption and investment spending will eventually lead to a decline in employment, as firms begin to recognise that their labour is insufficiently utilised. The decline in employment, in turn, means a drop in labour income, which, with a lag, leads to a further drop in consumption.

And that leaves the fourth (and possibly the nastiest) of the dangers, one that concerns the latitude for monetary policy intervention. As the Fed reduces interest rates to combat the crisis, the dollar is falling. This is leading to higher import prices and oil prices in the United States, putting upward pressure on inflation. The greater this inflationary pressure – which is currently in excess of 4 percent – the more difficult it will be for the Fed to reduce interest rates in the future, without running a serious risk of inflaming inflationary expectations and starting a wage-price spiral. U.S. firms and households will gradually recognise this dilemma and the bleak prospect of little future interest rate relief will further dampen consumption and investment spending.

Eventually, of course, the decline in spending will lead to a decline in inflation, but this will only happen with a lag. The longer the lag turns out to be, the longer the period over which the U.S. economy will endure stagflation, that is, a cruel combination of rising prices and falling aggregate demand. Much hinges on how persistent U.S. inflation is. More persistent inflation will inevitably give rise to higher inflationary expectations, leading gradually to higher inflation, and so on. It took central banks over a decade, in the 1980s and early 1990s, to get inflationary expectations under control, and the fruits of this battle are now in danger of being lost.

Global implications
The international financial crisis and the decline in the U.S. economy will inevitably have an adverse effect on the growth of the world economy. Europe and the emerging markets of Latin America and the Far East cannot fill the gap that the U.S. economy leaves. There exists no economic mechanism whereby a drop in the U.S. aggregate demand will be matched by a correspondingly large increase in aggregate demand elsewhere. Germany and other European economies highly exposed to the vagaries of international trade will certainly feel the pinch.

In the longer run, the prospects for the world economy look much brighter. Eventually U.S. house prices will stabilise, rising exports will help the U.S. economy recover, the fall in world demand for goods and services will reduce the price of raw materials, U.S. households will learn the importance of saving, and global imbalances will correct themselves.

But as Keynes said, in the long run, we are all dead.

Will Credit-Default-Swaps-Induced Distortions Continue?

A short piece in the Financial Times suggests that imbalances in the credit default swaps market are likely to continue, and those problems redound to the cash bond markets, distorting the prices at which companies can raise funds.

Admittedly, due to reduced anxiety in the funding markets, credit default swaps prices have generally improved. However, the lack of protection sellers (those willing to assume risks) means that CDS protection is generally more costly. That might seem a non-issue (is the CDS price now "wrong" or were earlier prices "wrong") except that the CDS market is so much larger than cash bond markets that CDS prices now determine borrowing costs for corporate borrowers, so distortions in the CDS market have real-world impact. From an earlier Bloomberg story:

Credit trading models used by Wall Street have gone haywire, raising company borrowing costs even as Federal Reserve Chairman Ben S. Bernanke cuts interest rates.

General Electric Co. is one of five U.S. companies rated AAA by both Standard & Poor's and Moody's Investors Service, making its ability to repay debt unquestioned. Yet when the Fairfield, Connecticut-based firm sold 2.25 billion euros ($3.35 billion) of five-year bonds last week, its annual interest payment was $17 million higher than on a sale nine months ago.

Borrowers from investor Warren Buffett's Berkshire Hathaway Inc. to Germany's HeidelbergCement AG face the same predicament. Yields on $5.12 trillion of corporate bonds tracked by Merrill Lynch & Co. average 2.05 percentage points more than U.S. Treasuries, the most since at least 1997.

The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent -- a mathematical impossibility, according to UBS AG.

``The credit-default swap market is completely distorting reality,'' said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country's biggest cement maker. ``Given what these spreads imply about defaults, we should be in a deep depression, and we are not.''

This Financial Times article explains why seeming mispricings of this sort are likely to persist:

Is something wrong in credit markets? A simple look at the risk premiums, or spreads, on cash bonds and those on credit derivatives shows a heightened dislocation has developed since last summer, says Geraud Charpin at UBS.

The market, he says, has become polarised between buyers of risk that focus on new corporate issues (cash bonds) and sellers of risk that focus on credit default swaps (CDS), the derivatives that provide a kind of insurance against non-payment of corporate debt.

“In cash bonds, companies [that wish to borrow money] provide an offset to investors [who wish to lend]. This allows an equilibrium between supply and demand to form. In CDS, the lack of supply side creates a major imbalance, which increases volatility.”

The problem is that complex investments known as synthetic collateralised debt obligations previously acted as big buyers of credit risk. But these products have withered and left the CDS market dominated by people who want to sell credit risk (go short, or buy protection) when things look bad, or switch to buying back credit risk to cover their shorts when the outlook improves.

“Until the synthetic CDO market re-emerges, the CDS market might be doomed to heightened volatility, moving above cash levels in bear runs (everyone buying protection) and below in bull runs (everyone covering shorts), while volatility of cash spreads will be tamed by supply/demand forces.”

Unrepentant, Intransigent Lenders: Overplaying Their Hand?

Still out of town, still behind the eight ball, so forgive the terseness with today's offerings.

Two items provide further evidence that lenders not only have little sense of responsibility for the problem they helped create, but worse, their unwillingness to reform in the face of considerable public pressure. As we noted, with regulators capitulating in serious ways to their demands, so far this take no prisoners strategy looks like a winner. But the housing crisis is only in its early stages, and as it intensifies, the high-handedness and lack of remorse is sure to backfire,

Although payday lending is typically to a cohort even less creditworthy than subprime borrowers, it too is coming under harsh scrutiny as the public is becoming less tolerant of predatory lending (and yes, I have trouble with the argument that this is a valuable service, since the payday lender's objective is to find/create clients who become dependent and keep rolling their loans over).

So it confirms the industry's lousy image when a payday lender threatened to yank its donations to foodbanks unless they withdrew from the Center for Responsible Lending, which among other things, is seeking to put curbs on payday lenders. So its contributions had nothing to do with helping the poor, as the like to claim, but was, as one would expect, about buying allies

From the Wall Street Journal:

Rent-A-Center Inc., a rising power in the payday-loan industry, pressured an Ohio food-bank association into quitting a coalition of activists that advocates a crackdown on the business.

In a series of telephone calls in recent weeks, Rent-A-Center executives warned America's Second Harvest and its Ohio affiliates that Rent-A-Center would yank charitable contributions from hunger programs in the state unless the local food banks withdrew from the Ohio Coalition for Responsible Lending. The coalition has been pressing the state legislature to cap high interest rates charged on payday loans.

Wednesday, the Ohio House passed a bill that would cap the annualized interest rate on payday loans at 28% and limit borrowers to four loans of $500 each a year. Ohio's governor said last week that he supports a cap.

Rent-A-Center currently charges interest rates on one-week payday loans that are equivalent to an annual rate of as much as 782%, according to a company Web site. In Ohio, the average borrower pays $15 for each $100 borrowed, and the typical loan is repaid in 19 days, a 288.16% annual rate, the company says.

"We must have our name taken off the Web page of the Ohio Coalition for Responsible Lending," Anne Goodman, chairman of the Ohio Association of Second Harvest Foodbanks, wrote in an email to a subordinate April 18. America's Second Harvest, the Ohio association's parent, "got another call today from Rent-A-Center, as they thought it would be gone by now."....

Bill Faith, legislative chairman of the Ohio Coalition for Responsible Lending, said it is "out of bounds" for a corporate donor to try to use its financial clout to change the public-policy position of a nonprofit organization. "They're just trying to buy people off," Mr. Faith said.

Charles W. Hall, a tax lawyer at Fulbright & Jaworski in Houston, said Rent-A-Center's action falls into a "gray area." In general, a company can't deduct a charitable gift if it receives something of value in return, but it is unclear whether pressuring a charity would invalidate the deductibility of a gift, Mr. Hall said.

Rent-A-Center executives said the rate cap proposed in Ohio would force the company to shut down its Cash AdvantEdge operations in the state, home to 53 of the company's 276 financial-services locations nationwide. Such a bill "will end the payday-lending industry in Ohio, like a similar rate cap did in Oregon last year," Dwight Dumler, Rent-A-Center's assistant general counsel, wrote in answers to questions about the company's Ohio lobbying campaign.

The company, like others in the business, says it helps people on the financial edge get through to the next paycheck. Mr. Dumler said consumers would otherwise have to use "more-costly short-term credit, such as overdraft protection, late fees, and offshore Internet lending."

Consumer advocates and antipoverty activists say poor borrowers often have to take out other loans to pay off the initial ones, accumulating penalty fees and debts several times the value of the original loans.

These arguments caught the attention of state lawmakers from both parties, as well as Gov. Ted Strickland, a Democrat, who last week threw his weight behind the idea of a rate cap. "Greed is a nasty business," said state Rep. William Batchelder, a self-described Reagan Republican from Medina County and one of the main sponsors of the rate-cap bill.

Credit Slips give a nice recap of the action so far this week (!) on the efforts to impose tougher rules on mortgage lenders. I recommending reading the entire post, but the juiciest bits were at the beginning and end:

Here's a mortgage crisis chronology for this week, as reported by the New York Times and Washington Post. Can you guess what these articles have in common?

On Sunday, Michelle Singletary's The Color of Money column discussed Treasury Secretary's Henry Paulson's recommendation to create a Mortgage Origination Commission that would promulgate standards for mortgage loan officers and would rate and report state efforts to license and regulate mortgage brokers. In her view, a new Commission isn't needed. Instead, she argues that what we need to do is send some of these people to jail. Rather than have a commission talk about their fraudulent acts, she suggests that we need to criminally prosecute loan officers who have engaged in fraudulent lending activities.....

So what do these news reports have in common? First, the mortgage industry seems unwilling to voluntarily reform itself. Second, any attempt to regulate the industry will be met with the claim that doing so will do no good and will only exacerbate the credit crisis. Third, no one in the government seems to want to take truly bold steps to do anything meaningful anytime soon, and everyone seems happy to engage in long discussions (in committees or on commissions) about the housing crisis. Fourth, the Fed and members of Congress appear unwilling to alienate the powerful financial services industry.

Links May Day 2008

Criminals try to 'copyright' malware PhysOrg

Next decade 'may see no warming' BBC

Nuclear's CO2 cost 'will climb' BBC

Where Are They? Why I hope the search for extraterrestrial life finds nothing MIT Technology Review

Pricing power:
signal versus noise Tim Price

McCain's Health Care Plan: Why It's Another Dumb Idea Robert Reich

Republicans Plan a Giveaway: for the Wealthy ataxingmatter

The Slippery Slide Towards Insolvency Michael Panzner

Borders still matter; “the world isn’t as flat as it used to be” Brad Setser

Antidote du jour:

Fed Weighs Increasing Term Auction Facility Yet Again

When the Fed's innovation, the Term Auction Facility, which is in effect an improved discount window, was implemented last December, its size was $40 billion, which was considered extraordinary, a sign of how desperation conditions in the money markets were. Now that several increased put the facility is $100 billion, the banking community and the press treat the idea that it might need to be enlarged yet again as something comparatively routine, rather than a sign that banks are still under serious stress despite concerted measures by central banks,

Yet again, the Fed is acting out the cliche, "if all you have is a hammer, every problem looks like a nail." Central banks know how to deal with liquidity crises; the TAF and its other facilities are well suited for that sort of problem. But fundamentally, the financial services industry is suffering from a solvency problem. Too many of the assets on its balance sheets contain loans to borrowers who lack the ability (and in some cases the desire) to make good on their debts. Forcing interest rates into negative real interest rate territory will only help a portion of the underwater borrowers. In addition, a distortion this severe is almost guaranteed to produce more misallocation of capital, which is not good for the US in the long term. And if the Fed miraculously manages to keep asset values from falling further, it is merely delaying the day of reckoning, and Japan is the poster child of the results of such a Phyrric victory.

From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke may need to step up his effort to unfreeze bank funding markets as a surge in borrowing costs blunts the impact of the cash auctions the central bank introduced in December.

The cost of obtaining funds for three months has risen by 0.33 percentage point since the Federal Open Market Committee's last meeting on March 18. The jump may force homeowners with variable-rate mortgages and some companies to pay more on their loans at a time when economic growth is faltering.....

``There's clearly a need for the Fed to do more,'' said Charles Lieberman, a former New York Fed economist who's now chief investment officer of Advisors Capital Management LLC in Paramus, New Jersey. ``The underlying problem'' is that banks and other investors are ``still nervous'' about lending to each other, he said.....

Investors' focus may instead shift to the Fed's attempt to stem the surge in bank funding costs that began in August, when the subprime-mortgage market's collapse spurred concern about losses at financial firms.

The three-month London Interbank Offered Rate for dollars has climbed to 2.87 percent from 2.54 percent on March 18.

Increases in Libor and other rates are ``a pretty clear indication that liquidity remains an issue or that term liquidity remains scarce,'' said Dean Maki, chief U.S. economist at Barclays in New York and a former Fed researcher. ``The Fed's made pretty clear they're going to continue to attack those problems as needed.''

The TAF is one of several Fed initiatives to unblock credit markets, along with direct loans to investment banks and $29 billion of financing to secure JPMorgan Chase & Co.'s takeover of Bear Stearns Cos. Investors have responded, buying a record $45.3 billion of corporate bonds last week and spurring an 11 percent rally in the Standard & Poor's 500 stock index from the year's low last month...

Another gauge of bank funding costs, the premium on Libor over the overnight indexed swap rate, a measure of what traders expect for the Fed's benchmark rate, reached 87 basis points on April 21. That was the highest since the Fed announced the TAF on Dec. 12.

Bigger TAF operations would probably slow or reverse the increase in borrowing costs, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ...

Fed Governor Kevin Warsh, San Francisco Fed President Janet Yellen and three other district-bank presidents voiced concerns about rising prices this month.

``Federal Reserve officials view themselves as about done with policy easing,'' said Vincent Reinhart, who was the Fed's chief monetary-policy strategist from 2001 until September 2007. ``They probably want to signal that the easing cycle is over, at least for a while.''

Quelle Surprise! Bush Homeowner Rescue Program Falls Short of Low Expectatios

Last year, we were less than impressed with Bush's tightly bounded but widely touted plan to use the FHA, a traditional source of financing to low and middle income borrowers, to help salvage homeowners at risk of begin dispossessed. Note we have doubts about "rescue debtor" operations. Iin many cases, these borrowers had little to no equity in their home, which begs the question of why it is so awful for them to lose their home. Indignity, yes, tragedy, no.

But a cynical plan to do nothing while pretending to offer relief is even worse than standing pat. It gives homeowners and possibly mortgage investors false hope and forestalls discussion of the tough choices that need to be made (the residential housing market is simply too large for the Feds to rescue), But then again, if your aim is merely to leave this problem in the lap of the incoming regime, a Potemkin program like this is exactly the sort of thing you want.

Better yet, the FHA program appears to be falling well short of its modest goals. The Bushies said it would aid 80,000 delinquent borrowers in 2008. So far this year, the total in that category getting help in 2,000.

From the New York Times:

Fewer than 2,000 homeowners at risk of foreclosure have been helped by a Federal Housing Administration program that President Bush promised would help homeowners who had fallen behind on their mortgage payments, federal housing statistics show.

F.H.A. officials have asserted in recent weeks that more than 150,000 people have benefited from the program, which was intended to help troubled homeowners refinance into stable, government-issued loans. But the vast majority of participants have been homeowners who have made their mortgage payments on time, not the borrowers in crisis who were the targets of the president’s plan, the statistics show.....

More than 400,000 mortgages will be refinanced through F.H.A. Secure this year, officials say. Of those, only about 4,000 will be held by homeowners who have fallen behind on their payments, the statistics show.

“F.H.A. Secure, while a good idea, is not addressing the magnitude of the problem,” Senator Christopher J. Dodd, the Connecticut Democrat who is the chairman of the Banking Committee, said at a hearing this month. He is calling for legislation that would help many more troubled borrowers.

Scott Stern of Lenders One, an alliance of mortgage bankers based in St. Louis, called the program’s record with the neediest homeowners “a tragedy.”

“F.H.A. is helping borrowers who aren’t currently in trouble and that is fine,” Mr. Stern said. “But there is a specific subset of borrowers right now who are in trouble. The program needs to be helping people who need the help immediately.”

Housing officials say they have worked hard to reach such borrowers. In August, the program was tailored toward low-income homeowners who were falling behind because of interest rate increases on their adjustable-rate mortgages. The officials say that interest rate cuts by the Federal Reserve reduced the number of such people....

The F.H.A. still requires borrowers hoping to refinance to have made 10 on-time payments in the 12 months before they went into default. That will block many borrowers, said John Taylor, president of the National Community Reinvestment Coalition, which helps people in underserved communities get credit.

Martin Wolf on Reforming Agriculture

In a bit of synchronicity, food worries are getting prominent billing tonight in the media. The Financial Times" Martin Wolf sketches out some dimensions of snowballing agricultural problems and possible solutions.

Wolf's piece endeavors to cover a lot of ground, which means of necessity it gives short shrift to depth. It touches on the central yet only-now-meriting-discussion fact that high productivity agricultural production is energy intensive. It mentions only in passing that scarcity of potable water is also increasingly an issue, and as Australians know full well, agricultural uses often compete with household needs. And creating water for human consumption out of low quality water is often energy intensive (desalination reportedly is, membrane-based technologies far less so). While there are no easy answers, looking at problems in isolation is sure to lead to suboptimal solutions.

It also (an increasing pet peeve) fails to mention that the ag problems is a population and diet problem, and does not consider addressing those issues. Weirdly, there is an assumption that people can't/won't change their diets. Yet convention and social norms are very powerful forces. In US, but no one here is talking about the need for people in advanced economies to eat less meat and fish protein (as mentioned, it take roughly 10 grain calories to produce one food calorie). Note that does NOT mean becoming vegan, but shifting the proportions in one's diet (I'm amazed when I go to restaurants how big the piece of protein is relative to everything else). Will this happen quickly? Unlikely, but not talking about it as part of a program will assure it doesn't happen at all.

From the Financial Times;

Of the two crises disturbing the world economy – financial disarray and soaring food prices – the latter is the more disturbing....

The recent price spikes apply to almost all significant food and feedstuffs (see charts). Yet these jumps are themselves part of a wider range of commodity price rises. Powerful forces are linking prices of energy, industrial raw materials and foodstuffs.....

So why have prices of food risen so strongly? Will these higher prices last? What action should be taken in response?



On the demand side, strong rises in incomes per head in China, India and other emerging countries have raised demand for food, notably meat and the related animal feeds. These shifts in land use reduce the supply of cereals available for human consumption.

Furthermore, rising production of subsidised biofuels, further stimulated by soaring oil prices, boosts demand for maize, rapeseed oil and the other grains and edible oils that are an alternative to food crops. The latest World Economic Outlook from the International Monetary Fund comments that “although biofuels still account for only 1½ per cent of the global liquid fuels supply, they accounted for almost half of the increase in consumption of major food crops in 2006-07, mostly because of corn-based ethanol produced in the US”.

Meanwhile, aggregate production of maize, rice and soyabeans stagnated in 2006 and 2007. This was partly the result of drought. Also important, however, have been higher prices of oil, since modern farming is so energy-intensive. With weak growth of supply and strong increases in demand, cereal stocks have fallen to their lowest levels since the early 1980s. Declining stocks undermine the widely shared belief that speculation has driven the rising prices, since stocks would be rising, not falling, if prices were above market-clearing levels.



Vastly more worrying than speculation is the weak medium-term growth of supply. The rapid increases in yields of the 1970s and 1980s, at the time of the “green revolution”, have slowed. Given the stresses on water supplies, longer-term supply prospects would look poor even if diversion of