naked capitalism

Submitted by Lune.

As promised, the following is part II about the legislative process. While the first post was primarily about how Congress gathers information, this post will look at some of the forces affecting Congress’s ability to create good legislation. As you’ll quickly notice, IMHO, the news isn’t very good…

Anyone who watches Congress go about its business will note a certain bipolar proclivity to its actions: it will snooze as important issues fester; then, at a seemingly random moment, it will wake up, and, after a frenzy of hearings, speeches, and negotiations, it will write and pass enormous bills faster than a harlequin ghost-writer on crack.

The public is therefore left cursing Congress for its laziness and inaction, then cursing it for its hasty decisions and rushed, poorly thought-out laws. There seems to be no in-between.

The reality is that getting a bill passed is somewhat akin to laying siege to a castle (the castle being Congress and the policy advocates being the marauders).

A successful siege campaign in the Middle Ages could last years, and consisted of a slow grinding down of the inhabitants of the castle while building your siege weapons, training your forces, and probing the walls for weaknesses. Then, when a weakness was found (or created), all of a sudden, your forces would rush in, a huge, noisy battle would ensue, and very quickly, you’d either become the king of the castle, or be dead with your head proudly displayed on a pike. For someone watching just the castle, it can appear like years of humdrum tedium interrupted by sudden, random chaos.

The legislative process is a little like that (although being more civilized, we’ve replaced the pike with a symbolic skewering on the late night comedy shows).

Despite the occasional oddball bill that manages to sneak through, it’s actually quite difficult to get a bill signed into law. While any Congressperson can introduce any bill on any topic, the vast majority of those bills are never even considered in committee, much less make their way to a committee vote, full vote, conference, final vote, and (finally), a presidential signature. Take away the bills that Congress is required to pass every year (e.g. budget, appropriations, re-authorizations, etc.), and the percentage becomes even lower.

Thus, policy advocates understand that merely writing a bill and sitting and waiting for Congress to pass it is as futile as a solitary knight knocking on a castle door asking to be let in. Successful legislative efforts are often years (frequently decades) in the making, and involve a long process which includes gathering the data and research you need to make your case, developing your policy proposals, generating public support and attention to your issue, finding a few Congresspeople to be early champions of your cause, then starting the dreary slog through interminable rounds of hearings, amendments, negotiations, votes, etc. (usually repeated through multiple Congresses) until finally, hopefully, your bill is passed. Or not (if your sponsor loses his re-election bid or the Committee chairperson who loved your bill retires).

But occasionally, for some reason, your pet issue becomes thrust into the public spotlight. The New York Times puts it on the front page. A celebrity talks about it during his Oscar acceptance speech. Opinion polls list your issue as #3 on the list of America’s most pressing problems. Something Must Be Done. In other words, the castle has been breached. At this point, a mad scramble begins to find a plan, any plan, that has at least a marginal chance of convincing the public that it will solve the problem. And if your bill, gathering dust with each Congressional session, happens to be available, it will be passed and thrust in front of the President before you have a chance to say “But wait! I have one more amendment!”.

Believe it or not, this is the good news part of this post. Why good? Because in most of these situations, although to the public it seems that Congress just magically pulled a hundred-page bill from thin air, most of the times, that bill was drafted from the dozens of policy proposals, bills, and amendments floating around in and out of Congress for years being debated, refined, negotiated, etc. waiting for a chance to get attention.

A recent example is the Enron affair. Prior to Enron, corporate governance and accounting advocates have, for decades, been crafting proposals for stricter accounting rules, increased responsibility for board members, etc. And for decades, these proposals were nothing more than think tank position papers, or bills introduced and quickly forgotten at the beginning of each session. Then Enron broke, there was a mad scramble to address the issue, and ultimately, Sarbanes-Oxley was created as a hodgepodge of proposals that had been languishing for years.

On the upside, many of the individual proposals in Sarbanes-Oxley had been around for years. On the downside, the chaotic way in which they were combined left much to be desired. Just as the most well-laid siege tactics are frequently upended during the chaos of a castle breach, so can the final push to pass a bill undermine whatever merits the bill might have had in the first place.

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As bad as this process sounds, I believe it continues to get worse, for the same reason that decision-making in a lot of fields has deteriorated: decisions have become more complex, the volume of information that needs to be absorbed to be “knowledgeable” has exploded, and the time available to act has shortened.

As a historical example, the foundations of modern financial regulation rest on a series of laws passed in the New Deal era: The Securities Act of 1933, the Banking Act of 1933 (aka Glass-Steagall), the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. The first 3 were passed passed 4 and 5 years, after the crash of 1929. The last two pieces were passed half a generation (and more importantly >2 presidential terms) after 1929. In contrast, Enron imploded in the fall of 2001, and Sarbanes-Oxley was enacted in July, 2002, less than a year later.

In our current mess, if you count the Bear Stearns implosion as the start of our crisis (or at least the general recognition that it was something more than a contained subprime problem), we’re barely a year into it. Yet the pressure to do something is immense, for several reasons:

1) The press cycle used to be measured in weeks, then days, and is now hours or less, what with live interviews of talking heads on 24-hour news channels. That means Congresspeople are under intense pressure to respond to complicated issues very quickly. And since the press only has time for 5 second soundbites, the responses don’t need to be (and indeed can’t be) nuanced or sophisticated. While telephones, telegraphs, and telegrams were all present in 1929, they were only used for breaking major news events, and that trickle doesn’t compare to the barrage of news that gets transmitted instantaneously these days.

2) There is a tremendous first mover advantage in Congress just as in business. The first mover gets the most press coverage, gets to hugely influence the terms of the ensuing debate, and has a much higher chance of getting his/her bill passed, even if it’s worse than later efforts.

The window to be the first mover these days is very narrow, which decreases the time the first mover has to put his/her bill out there. While Congress can be cooperative, there is quite a bit of competition and jockeying for position on important issues. Congressional success is measured in terms of legislation passed, press attention garnered, and election funds raised, rather than profits as it’s measured in business, but the competitive atmosphere between Congresspeople, even within the same party, is quite similar to the business landscape.

For example, the reader will recall Grassley’s and Levin’s hedge fund regulation bill which was covered in this blog last fall. Its actual provisions were few in number, and poorly thought out. And it’s no surprise that it went nowhere. But it had a good title, “The Hedge Fund Transparency Act”, which meant it got good press for its sponsors, it put the industry on notice that moves were afoot to begin the regulatory process, and it allowed Grassley and Levin, two people who would otherwise have very little influence on hedge fund regulation, to at least place a marker on the issue that they wished to be included in future discussions.

In contrast, subsequent bills such as the Private Fund Transparency Act, the Hedge Fund Adviser Registration Act, etc. have garnered far less public attention (not to imply that their quality makes them deserving of more…).

3) The toll of fundraising and campaigning. Modern campaigns have become so expensive and drawn-out that fundraising and constant campaigning is slowly crowding out time spent actually legislating. In the past, Congress actually deliberated 5 days a week, and most people, after being elected, actually moved to DC and lived there. Believe it or not, Congresspeople — even those of opposing parties — used to play cards together, or get their families together for outings on the weekend, or meet socially during events in DC, just like regular co-workers in any office. That meant that even on days when Congress wasn’t in session, people were around to informally gather and form a milieu of continuous discussion, negotiation, and exchange.

Nowadays, Congress is in session for barely 3 days a week, and most elected officials keep their families in their district and fly home every week. Harry Truman famously derided the 1947-48 Congress as the “do-nothing” Congress for meeting for 108 days. In contrast, the 2006 Congress met for just 71 days. During those times, schedules are jam-packed with hearings, important votes, meetings with staff, etc. meaning important matters get triaged out due to scheduling conflicts. The rest of the time? Increasingly spent fundraising.

In essence then, the business of legislating has become secondary to getting elected. Congresspeople fly into DC for a few days during which time they scuttle from meeting to meeting, skipping or cutting short time in hearings or panels (part of the reason hearings are so lousy is because rarely do Congresspeople stay for the entire time, choosing instead to come in, ask their questions for the cameras, then leave), cramming in quick meetings with staff and key officials, hurrying to the floor to cast a vote when it’s needed, then flying out again, exhausted, to get back on the campaign and fundraising trail. In their absence, the staff manage the nitty-gritty of shepharding legislation.

While I’m under no illusions that the politicians of previous years were equally focused on their re-election, the demands of campaigning were definitely less, allowing more time to be spent on legislating.

So to sum it up:

1. There are lots of extensively researched, fleshed out policy proposals for almost any issue imaginable, floating around Congress for years and decades.
2. The complexity of problems has grown.
3. The urgency of “putting something out there” has shortened the time available to absorb the voluminous amount of information and proposals available and draft a good solution.
4. The exigencies of the modern campaign means that even in the shortened time available, there is a smaller proportion of that time (and mindshare) that is dedicated to the task of governing.

Submitted by Lune

(N.B.: this post, and a subsequent Part II regarding the legislative process, are focused on the political processes of DC rather than economics per se. However, to the extent that the future of the financial world is now being determined in Washington, I figured there might be some value for Naked Capitalism’s readers in better understanding the processes that are reshaping the economy and the financial industry.)

As the government becomes increasingly involved in the financial world, finance- and economics-types have by now become well acquainted with America’s answer to Japanese Kabuki: the Congressional hearing. Just as Kabuki is famed for its focus on dramatic poses and stylized maneuvers over story or plot, so the modern Congressional hearing now appears to be nothing but a set of ritualized maneuvers and poses (such as the Feigned Outrage, the Somber Gravitas, and the occasional Sleepy Grandfather), performed for the audiences, followed by a quick exeunt with little insight gleaned into the topic at hand.

While both can be highly valued for their entertainment value, Congressional hearings are supposed to have a higher purpose. That hearings have degraded so egregiously is indeed troubling. Yet to really understand the problem, one must place hearings within the context of the larger issue of how Congress informs itself about the issues of the day and uses that information to create policy. In that context, the Congress of today is doing both better and worse than the Congresses of before.

But first to answer the pressing question of the day: are hearings today really so much worse than hearings of yesteryear? Yes. At least the ones we’re interested in. And that’s primarily for two reasons:

1) C-SPAN: Hearings used to be about allowing Congress to gather information from experts / relevant sources so as to inform a committee’s actions; and in the absence of any means to score direct points with the public, that’s what most hearings used to be. But with the intense media coverage that important hearings get these days, they’ve turned into nothing more than scripted media events, with witnesses called not for their ability to illuminate an issue but to make political points, and questions and opening statements all crafted beforehand by staff and fed to the Congressperson for recitation (with appropriate Kabuki-esque melodrama) in front of the cameras.

That said, even today, not all hearings are that bad, for the simple matter that the vast majority of hearings get almost no media attention. Congress holds probably a dozen hearings a day when in session, most of which get dutifully taped by CSPAN and filed away in archives with nary a viewer or listener outside the beltway. You can get the schedule for any given day on THOMAS (and yes most of the hearings are as painfully boring as their titles imply…). In my experience, the hearings with the least amount of public interest tended to be closest to the ideal. While the topic may be mundane or arcane, without the pressure of media attention, there’s usually much more of a focus on gaining information. Unfortunately, this means that the most pressing issues of the day, generating the most public interest, tend to get the worst kabuki-type hearings, while the ones of least public interest are conducted in a more worthy fashion.

2) To counterbalance this tendency, however, Congress now has immeasurably better ways of gaining information than conducting hearings. Hearings were a relic of a time before telephones and rapid transit, when no piece of information traveled faster than a horse, and when just getting the experts together for a frank and spontaneous exchange was no small feat. These days, if a Senator wishes to speak with a panel of economists, he could get them on a conference call, if not have them fly in for an impromptu private discussion (not to mention he could read all their papers without having to meet them at all). In other words, part of the reason hearings have become so worthless for their original purpose is because their original purpose is often better served with more modern methods of information gathering.

A useful analogy is to the Library of Congress: originally the LoC was chartered to serve as a central repository of all the world’s information so as to make it easily available to Congress. At the time of the LoC’s founding, if a Congressperson was interested in an issue and wanted to learn how it affected both California and New York, and also read about how France and Britain addressed the same problem, he could write letters to a dozen libraries and government archives around the world, then wait six months as the requested materials slowly arrived, all the while hoping that there wasn’t some critical source that he didn’t know about and consequently didn’t request. Thanks to the LoC, he could instead send one request, and the LoC would search its extensive holdings that it had already painstakingly gathered, and send back an extensive (and frequently exhaustive) package of materials within a few days.

But now, when much of the world’s information can be looked up instantaneously on the internet, a Senator’s access to Google and LexisNexis is far more valuable. Yes, the LoC is still unbeatable when you need to hunt down some obscure or ancient source, but for the important issues of the day, the LoC is no longer needed.

On balance, the volume and quality of information available to Congress now, when all sources are taken into account, are vastly better than they were decades ago. It’s just that hearings are the public face of that information-gathering process, and they have degraded as they’ve become less useful.

So to answer our original question: are hearings useless these days? For the important issues of the day? Yes. But to address the broader point, does Congress have better or worse access to information than before? Undoubtedly better.

And now for a more subtle question: for all this extra information, is Congress actually better informed than before? Not necessarily. And that brings up the final wrinkle in Congress’s information gathering process.

As information has become more voluminous, specialized, and complicated, Congress very rarely uses primary research, since most elected officials and their staff are not academics or able to keep current with nor understand academic research. Conversely, as the process of legislating has become more complex, fewer researchers have a feel for how to translate their findings into policy proposals.

I’d assert that as a result, most staffers in DC get their policy ideas not from original academic work but from think tanks (a term I apply broadly to many foundations and public interest / advocacy groups). This isn’t because staffers don’t value academic work, but rather because it’s frequently difficult to translate academic findings and recommendations to fully fleshed out, politically viable solutions. And that’s frequently what think tanks do.

For example, an academic publishing a paper on the harmful effect of options volatility isn’t nearly as useful as an economist in a think tank who takes that paper and drafts a proposal for changing the CFTC guidelines to reduce that volatility. The academic economist usually doesn’t understand specific CFTC rules (although they probably understand the general regulatory environment), and the staffer usually doesn’t understand the arcana of Black-Scholes equations (although they probably understand the concept of options volatility and its side effects). The think tank economist can bridge that divide.

While this is all well and nice, lobbyists have figured out this weak link, and have taken advantage of it. While it’s fairly difficult for lobbyists to influence academic work (thanks to the long histories of most reputable departments, tenure, peer review, and the inbred nature of the ivory tower), it’s very easy to influence think tanks, and even set up whole think tanks for your own purposes. The conservative movement, for example, figured this out, and rather than fight for influence within “liberal” academic departments, created think tanks like the American Enterprise Institute, the Heritage Foundation, and the Cato Institute to bypass academia.

This hasn’t gone unnoticed by other lobbying firms. The most sophisticated lobbying efforts now center around surrounding policy makers within a world created and sustained by the lobbyists themselves. Thus, you have lobbyist-funded original research in academia, lobbyist-created think tanks translating that academic data into legislative proposals, lobbyist-sponsored mediagenic experts to go on TV / newspapers advocating those proposals and setting the terms of the debate, and lobbyist-generated astroturf (i.e. fake grassroots) campaigns to simulate voter approval and public pressure. Quite a far cry from when lobbyists literally just stood in the lobby of the Senate floor begging for a few minutes of the Senators’ time.

So in summary, hearings have become media non-events because they have been supplanted by more modern information gathering tools (while becoming more useful as PR thanks to CSPAN). The rise of those tools means Congress has access to more and better quality information than ever before. Yet the increasingly specialized and complicated nature of that information (and of the policy process) means there is a longer pipeline to digest that information and translate it to public policy. And finally, the longer that pipeline grows, the more vulnerable it has become to influence from lobbyists and other groups.

How this and other changes have affected the legislative process will be addressed in a subsequent post. Stay tuned!

Submitted by Lune.

As the Fed embarks on quantitative easing, a large number of economists have voiced concerns about the resulting inflation that we may face once the economy starts to recover.

The traditional tool for fighting inflation is contracting the money supply, usually by decreasing the reserves available, thus constraining the total amount of money that may be lent by the fractional banking system. Sceptics worry that since those reserves are now backed by illiquid — and frequently impaired — assets, the Fed will have a hard time shrinking the reserves outstanding.

In an article on voxeu.org, Robert Hall and Susan Woodward argue that the Fed now possesses another tool that would allow it to effectively reduce credit without decreasing reserves. In Oct, 2008, the Fed, in a break from long-standing policy, began paying interest on reserves held by banks. Hall and Woodward argue that the differential between the interest paid on reserves and the federal funds rate now forms another variable which the Fed can use to control the money supply independent of any manipulation of the amount of reserves outstanding:

When the Fed pays interest on reserves at a rate well below market rates – in particular, well below the Fed funds rate governing borrowing and lending among banks – banks economize on reserves. If the margin between the Fed funds rate and the reserve rate is large, say several percentage points, banks will hold only required reserves. In this case, standard old-fashioned monetary theory applies, taught to generations of freshman principles students as the “multiple expansion of deposits.”

Suppose we start with deposits of $100 billion and reserves of $10 billion, so banks hold no reserves in excess of requirements. Then the Fed creates another $1 billion of reserves. Banks will expand their activities to try to avoid holding excess reserves, which are undesirable because they pay interest far below market rates. The economy expands as a result, depositors hold more in their checking accounts – $110 billion to be precise – and banks no longer hold excess reserves. The economic expansion is a combination of more real activity and higher prices. An expansion of reserves raises the rate of inflation over some period, generally thought to run from about a year after the expansion to around four years.

This conventional analysis always applied when the Fed paid zero interest on reserves and market rates were in the range of 5% or more. Banks used sharp-pencil policies to avoid holding excess reserves. Manipulation of the quantity of reserves gave the Fed powerful and direct and direct control over economic activity and inflation.

Today’s situation: No risk of excess inflation

When reserve interest rates and the Fed funds interest rate are close to each other, the situation is quite different. Banks are happy to hold excess reserves which pay just as much as could be earned on other safe investments. Expansion of reserves results mainly in expansion of excess reserves and has little effect on bank lending. Rather than stimulating economic activity and raising the volume of bank deposits, an expansion of reserves just adds to banks’ holdings of reserves. The Fed loses its control over economic activity. In particular, expansion of reserves is not inflationary when the reserve rate and Fed funds rate are the same. There is no risk of excess inflation in today’s economy.

In other words, if the interest paid on reserves is significantly less than the federal funds rate, then banks are quick to use the additional reserves as a basis to lend, while if the interest paid is close to the federal funds rate, then the banks will simply continue to accumulate reserves without increasing lending.

This may by one additional factor why banks have been sitting on all their extra cash given to them by the Fed rather than to start using it to lend (although other factors also exist, such as the fact that most of their balance sheets are still quite impaired, and that there are very few credit-worthy borrowers left in the current economy, most of whom are paying down their debt rather than looking to increase it, etc.)

If Hall and Woodward’s analysis is correct, then even if the Fed is unable to withdraw reserves fast enough, they might still be able to avert inflation by equalizing interest on reserves and the federal funds rate, thus disincentivizing banks from extending credit.

The basic point emerging from the analysis of the role of the reserve interest rate is simple: The margin between the Fed funds rate and the reserve rate is a potent new tool for stabilizing the economy. When the Fed wants to expand, it should raise the margin. In today’s economy, this would call for a negative reserve rate, that is, a charge to banks for holding reserves. When the time comes to move to a tighter policy, the Fed should lower the margin. At that time, the Fed would raise the reserve rate for two reason: first to reduce the margin and second to follow increases in market interest rates that will occur in a recovery.

So the question John Taylor posed – how can the Fed control inflation in coming years when it is committed to have a large volume of reserves outstanding to finance its purchases of illiquid assets? – has a simple and effective answer: The Fed should raise the rate its pays on reserves as needed to control economic activity and inflation. It is unnecessary for the Fed to cut its reserves to low levels once the economy approaches normal conditions. Rather, it only needs to raise the reserve interest rate to a point sufficiently close to market rates to make banks willing to hold excess reserves.

Regardless of future actions, Hall and Woodward point out that the Fed’s current actions are running counter to their stated goals:

Raising the reserve interest rate is a contractionary measure. A higher interest rate on reserves makes banks more likely to hold reserves rather than increasing lending. The Fed’s decision to raise the reserve rate from zero to 75 basis points just as the economy entered a sharp contraction in activity is utterly inexplicable. Fortunately, the Fed lowered the reserve rate subsequently, but the continuation of a positive reserve rate in today’s economy is equally inexplicable. [Emphasis in the original]

Some economists have proposed that the Fed charge banks for holding reserves, an expansionary policy worth considering. With the Fed funds rate at around 15 basis points, it would take a charge to restore the differential that drives banks to lend rather than hold reserves. Were the Fed to charge for reserves, they would become the hot potatoes that they were in the past, when the reserve rate was zero and the Fed funds rate 4 or 5%. Banks would expand lending to try not to hold the hot potatoes and the economy would expand. There is no basis for the claim that the Fed has lost its ability to steer the economy. (However, the Fed would have to go to Congress to get this power, as it did to get the power to pay positive interest on reserves.)

While Hall and Woodward’s analysis about bank behavior in the face of variation in the reserve rate / fed funds rate differential is insightful, the end-result is something well studied, namely the manipulation of reserve ratios to meet macro-economic goals. In essence, lowering the reserve rate / fed funds rate differential leads to de facto higher reserve ratios, leading to a contractionary policy similar to de jure higher reserve ratios such as a central bank explicitly raising minimum reserve requirements (for example, China’s central bank frequently changes minimum reserve requirements to meet macro-economic goals). Thus, this is not necessarily a new tool so much as a new impementation of an old tool.

One other criticism is that Hall and Woodward pay no attention to the political pressures that would lead the Fed to improperly use this tool. Everyone knows the goal of the Fed is to take away the punch bowl just when the party’s getting started, but recent history has shown the Fed unwilling to be such a party pooper. Regardless of the tools available, the Fed must have the independence to take politically unpopular decisions. Today’s Fed, behaving more like an off-balance sheet special purpose vehicle of the U.S. Treasury, is hardly that independent actor.

Indeed, the Fed’s current actions are telling. Hall and Woodward label the Fed’s current reserve rate as inexplicable since it directly contradicts the goal of getting banks to start lending. Yet it’s highly explicable: despite the macroeconomic damage being done by paying interest on reserves when the federal funds rate is so low, the Fed is loath to give up this method of funnelling yet more public money onto bank balance sheets. And you can be sure that any Fed moves towards charging banks for their reserves will be met with howls of protest (along with armies of lobbyists).

So in the end, while the reserve rate constitutes yet another tool in the Fed’s arsenal of macro-economic levers, we are back to the original problem, dating at least to Greenspan’s tenure, of how to get the Fed to use the tools it already has.

Submitted by Lune

Roll Call is reporting (subscription required) that the House and Senate are taking up measures for taxing bonuses paid out by companies in 2009 that accepted bailout money:

House and Senate leaders moved at breakneck speed Wednesday to turn outrage over bonuses at American International Group and other bailed-out companies into retribution, with votes beginning today to impose punishing new tax provisions on the firms.
…

AIG Chief Executive Officer Edward Liddy said Wednesday that he had asked employees to voluntarily return at least half of the bonus money, but lawmakers dismissed that move as insufficient.

The new tax measures being offered by House and Senate lawmakers differ, but both would apply broadly to employees of companies receiving federal bailout help, not just AIG.

…

Bonuses paid in 2009 to employees of companies that accepted more than $5 billion in government aid would be subject to a 90 percent tax rate in the House bill, [Chairman of House Ways & Means Cmte, Charles] Rangel said. Employees with total incomes of less than $250,000 would be exempt.

…

As the House pressed ahead, the Senate Finance Committee was ironing out the details on a proposal to tax bonuses of any firm receiving government rescue funds at 70 percent. The proposal by Chairman Max Baucus (D-Mont.) and ranking member Chuck Grassley (R-Iowa) could be introduced as soon as today.

Grassley also requested an investigation by Treasury Department Inspector General Eric Thorson to look into the agency’s role in the bonuses.

Senators also continued to spar over a provision dropped in the $787 billion stimulus package that would have taxed bonuses paid by bailed-out firms.

“Clearly it has to be done. It should’ve been done,” said one of the sponsors, Sen. Olympia Snowe (R-Maine), adding that she supports Baucus’ plan to impose excise taxes on executive bonuses.

Also interesting to note is that it appears that Congress is growing impatient with Obama and his team, and is moving ahead with measures that Obama’s economic team (namely Geithner and Summers) oppose. You’ll recall that in February, the NY Times reported that:

The Obama administration’s new plan to bail out the nation’s banks was fashioned after a spirited internal debate that pitted the Treasury secretary, Timothy F. Geithner, against some of the president’s top political hands.

In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.

Mr. Geithner, who will announce the broad outlines of the plan on Tuesday, successfully fought against more severe limits on executive pay for companies receiving government aid.

He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.

In the end, Congress went along with Geithner and Obama. But now we’re seeing the following (again from Roll Call):

Meanwhile, a parallel effort by the House Judiciary Committee to authorize the attorney general to go after “excessive” bonuses cleared the panel Wednesday and Chairman John Conyers (D-Mich.) said the bill could go to the floor next week, even as Democrats and Republicans on the committee worried it had been rushed too quickly and may be unconstitutional.

Republicans, for their part, trained their ire at the Obama administration and the growing bailout tab, with a few calling on Treasury Secretary Timothy Geithner to resign.

But Minority Leader John Boehner (R-Ohio) said during a Wednesday press conference with Senate leaders that more needs to be known before Geithner’s fate can be decided.

…

House Financial Services Chairman Barney Frank (D-Mass.) said he is strongly urging the administration, as majority shareholders in AIG, to file a lawsuit against the recipients of the bonuses.

“That’s the cleanest way to do it,” Frank said.

The Massachusetts Democrat, who had earlier suggested a government takeover of the firm, also threatened to demand a subpoena if necessary to obtain names of AIG’s bonus recipients, although Liddy urged him not to do so over fear about the safety of his employees after receiving numerous death threats.

It appears that Congress may finally be growing impatient with Obama. If these Congressional initiatives pass (and Speaker Pelosi seems likely to push these through in the next couple of days), they will be a direct rebuke to Geithner’s vision of providing bailout money with minimal strings attached. While the effectiveness of these new tax plans is yet to be seen (I have no doubt executives will be hiring the best tax lawyers around to skirt the regulations), just the fact that Congress is moving more quickly than Obama on these matters is bad news for the Administration.

Obama still needs credibility with and deference from Congress for coming legislation to deal with the automakers (scheduled to present their viability plans by the end of this month, and likely requiring further federal funds), plus any new initiatives after the G20 meeting, plus whatever random blow-up du jour in the financial world that comes our way. A loss of that credibility would be devastating to his ability to shepard further legislation through Congress. Hopefully, he’s learning his lesson fast and will start taking into account the interests of the common weal rather than just the interests of Geithner and his Wall St. pals.

[Update 1]
Rangel has released the text of his bill: H.R. 1586.
Also, (surprise surprise), the banking industry’s lobbyists are coming out in full force. As reported by Roll Call:

Financial services lobbyists have moved into hyperdrive, engaging in a behind-the-scenes counterattack after lawmakers trained their eyes on all bonuses paid out by struggling banks.

Banks that took millions of dollars in federal bailout money and their trade groups held several conference calls Wednesday to figure out how to respond to the swift-moving bonus bills, according to lobbyists who participated in the calls.

…

The banks’ main goal is to narrow the breadth of the legislation as much as possible, and they are targeting key players on the House Financial Services Committee and Senate Banking, Housing and Urban Affairs Committee.

One interesting caveat: many lobbyists themselves might come under the tax provisions:

Lobbyists who work for federally bailed-out banks also have a vested interest in seeing the legislation stopped. Most senior lobbyists at banks such as Citigroup, JPMorgan Chase and Bank of America, earned well over the $50,000 bonus threshold in the Senate legislation.

Still, as some of those lobbyists look to exit struggling banks, not everybody is rushing to weigh in.

Some in-house lobbyists are reluctant to use their own political capital to push back on the issue, given the widespread bipartisan anger over bonus payments, according to a financial services lobbyist.

I’ll post an update when I can get a public link for the Senate’s bill.

Folks, if you wish to see this legislation passed, you know what to do. (How many constituent phone calls or letters does it take to outweigh one lobbyist’s opinion? Quite a few, unfortunately…)

Submitted by Lune

On March 5th, the Bank of England announced that for the first time in its >300 year history, it will begin quantitative easing to lower interest rates and increase the UK’s money supply.

Details from The Telegraph:

The Bank’s Monetary Policy Committee voted to cut interest rates by half a percentage point to a new historic low of 0.5pc, and said it would immediately pump £75bn of cash into the economy.

The sweeping move – known as quantitative easing and considered to be the “nuclear option” for central banks – was expected, but the speed and scale of the initial investment came as a surprise.

…

In a letter to the Bank’s governor Mervyn King, published today, the Chancellor authorised the MPC’s request to spend a total of £150bn on government debt and private sector assets.

The Bank said the majority of the new money will be spent on government debt, or gilts, with a maximum of £50bn spent on private sector assets to increase the flow of credit available to businesses.

For Americans (and Zimbabweans) who now view any monetary figure with less than 12 zeros behind it with a jaundiced eye, £150bn is indeed a large sum. Per The Telegraph:

The sheer scale of the operation is illustrated by the fact that the entire corporate bond and commercial paper market in the UK is worth only £57.5bn, while the amount of gilt-edged government debt eligible for the Bank’s auctions totals £250bn.

It also represents ~10% of the UK’s GDP.

In one welcome sign, yields on gilts (British government bonds) have dropped significantly since the announcement:

With investors piling into gilts in anticipation of the auctions, the first of which is next Wednesday, gilt prices jumped by the biggest amount for at least 17 years, with some declaring it the most dramatic day in UK government debt in history. A rise in gilt prices pushes yields lower.

“For gilt yields to move by 30 basis points in a month is a big move,” said Philip Shaw, of Investec. “For it to move that much in a day must be pretty much unprecedented.”

The 10-year benchmark gilt yield dropped by 32 basis points to 3.32pc.

This will hopefully lead to lower interest rates for private borrowers.

While the BoE is probably doing the right thing, it is troubling that the UK’s economic conditions have become so dire that the “nuclear option” of last resort becomes the only choice available.

As Bloomberg reports:

The pound fell to its weakest in more than five weeks against the euro after Britain’s housing sales slipped to the lowest level since at least 1978 and manufacturing shrank the most in four decades.

…

Factory production dropped 2.9 percent in January from December, the Office for National Statistics in London said. Economists in a Bloomberg survey predicted a 1.4 percent decline. Manufacturing shrank 6.4 percent in the three months through January, the most since records began in 1968.

…

Gross domestic product contracted 1.5 percent in the fourth quarter, the most since 1980, a report on Feb. 25 showed.

It remains to be seen whether the BoE’s actions will have the intended effects or whether the large potential downsides to QE overwhelm any benefits to be had. At any rate, it will be instructive for American policy makers to watch the UK’s experiment with QE before possibly embarking on the same path in the near future. Of course whether they actually internalize any lessons to be learned from this opportunity is a different matter…

Submitted by Lune

This blog and many other authors have pointed to the large moral hazards that the federal government’s actions have created so far. It was typically expected that these moral hazards would play out in the next cycle of boom/bust, with financial players taking bigger risks for their own gain while expecting public bailout when the inevitable bust began.

Unfortunately, it appears that moral hazard is making its appearance rather early, and for GM, not in a good way, either.

As has been reported, GM is on the verge of declaring bankruptcy. As part of the conditions for their initial Federal infusion, GM is required to prove its viability as a going concern to the federal government’s auto task force by March 31st.

Part of that viability is restructuring its debt, lowering payments to its bondholders, and reducing outstanding principle as well.

Yet GM’s bondholders have so far been unwilling to go along. According to the Financial Times, in February:

General Motors and its bondholders failed to reach a deal on a debt restructuring even as the carmaker requested additional federal aid as part of a viability plan submitted to the US government late Tuesday.

Agreement from bondholders to cut GM’s debt is part of the US government’s terms for a $13.4bn loan granted to the carmaker last year.
…

In the run-up to the deadline, bondholders had been pushing for what they feel is more equitable treatment with other parties in the restructuring.

The original loan terms dictate that GM must reduce $27.5bn in unsecured bonds by two-thirds, which would be the equivalent of cutting the face value of the bonds to just more than 30 cents on the dollar.

Some of GM’s long-term bonds are trading about 15 cents on the dollar.

Still, bondholders have bristled because they feel their concessions are not balanced with those of other groups.

I suspect what has GM’s bondholders bristling is not necessarily their position vis-a-vis the UAW or GM’s other stakeholders, but rather the treatment received by GMAC’s bondholders when GMAC was bailed out.

As detailed by the Detroit Free Press:

As part of its drive for government aid, GMAC needed to convince bondholders to swap 75% of some $38 billion in debt for equity. Bondholders held out for better terms, eventually turning in only 59% of the bonds sought. Federal officials stepped in anyway, injecting $6 billion into GMAC and allowed it to become a bank to prevent its collapse.

The rescue drove up the value of GMAC’s debt – essentially rewarding the bondholders who said no, and setting a tough precedent for GM.
…
[Rod Lache, automotive analyst at Deutsche Bank] says given the results from the GMAC swap, GM probably won’t be able to get all of the bondholders to agree to the concessions its needs…

While GM can force bondholders to accept a restructuring in bankruptcy, the point of the federal bailout of GM was to allow it time to come to a voluntary agreement with all its stakeholders and avoid the supposed disruption and chaos of a reorganization done under bankruptcy. Yet by being lenient with GMAC’s bondholders during its bailout, the federal government has made it more difficult for GM to satisfy the terms of its own bailout package.

GM bondholders (probably correctly) perceive that a federal government that didn’t allow GMAC to go bankrupt even when its own rather generous criteria weren’t met will be highly unlikely to allow GM to go bankrupt regardless of the costs. And indeed, GM bondholders are probably wondering why they need to take a haircut on their bonds when the counterparties of Bear Sterns, Lehman, and AIG are being made whole at par after investing in far riskier securities.

Discussions are apparently continuing between GM and its bondholders, and barring last minute extensions from the government, GM needs to present a final plan by the end of this month. But in this game of chicken, the vast moral hazard the federal government has created has already strengthened the bondholder’s resolve, much to the detriment of GM’s negotiating position and the success of the government’s original bailout plan.

One of the primary lessons we are learning from the current financial debacle is that the lack of transparency in the OTC derivatives markets is one of the big reasons for the complete breakdown of those markets. Furthermore, the lack of appropriate oversight into those markets allowed problems to fester rather than being noticed and dealt with sooner.

I, along with others in the blogosphere and the MSM have called for greater regulation of these OTC markets as a means to prevent the disasters that have befallen such instruments as CDOs, CDSes, ABSes, etc. While the exact type of regulations required is certainly being fiercely debated, President Bush, Secretary Paulson, Fed chief Bernanke, and indeed, even many Wall Street heads have all admitted the need for more regulation and oversight of some type.

Well, some lessons are never learned. Just as the nation’s policy makers are discussing how to bring new and unwieldy instruments such as credit derivatives under appropriate regulation, a consortium of investment banks has proposed creating a private market for plain equities, a market which does not currently seem to be suffering from its current regulatory apparatus.

Behold, Project Turquoise (Hat tip Mara for mentioning it in the comments):

Project Turquoise, the share trading system backed by a group of the world’s largest investment banks, will allow transactions both on-exchange as well as in “dark liquidity” pools, where firms offer to buy and sell large blocks of shares away from public sight.

Speaking at an Exchange Forum conference in London, Phillip Hylander, co-head of European equities at Goldman Sachs (NYSE:GS) , set out for the first time the broad outlines of the business model that has promised to bring more competition to European share trading.

“Turquoise is to be a hybrid that will incorporate a public order book and a non-public order book,” Mr Hylander told the conference. “Turquoise will be an aggregator of ‘dark pools’.”

Project Turquoise was apparently initially dreamed up as an alternate stock exchange that would compete with European exchanges such as the LSE, thus leading to lower trade commisions. This would have been a welcome development. However, in addition to its public exchange facilities, Project Turquoise now aims to enable private placements of large lots of stock without the need for public disclosure of those trades as would be required if they were executed on a public exchange. While firms engaging in such trades may view such disclosure requirements as “burdensome regulation”, it’s that disclosure that forms the basis for policing against such illegal practices as pump-and-dump and insider trading, while ensuring that for any given time, there is only one best bid and offer which is freely available to anyone who wants it.

Furthermore, it’s precisely those types of private deals that contributed to the current collapse of OTC markets by hindering the normal market processes of price discovery and aggregation of liquidity.

These “dark liquidity” pools are already casting a long shadow on the traditionally open American equities market. According to Reuters last year:

Top IPO underwriter Goldman Sachs Group Inc. (GS.N: Quote, Profile, Research, Stock Buzz) this week launched a platform allowing an exclusive club of big investors to trade unregistered, privately placed securities, in the latest challenge to U.S. equity markets.

Private placements have become a big deal on Wall Street, another alternative for companies who want to raise capital but don’t want the regulatory and disclosure requirements that come with a public listing.

. . .

Last year [2006], according to Nasdaq, $162 billion of capital was raised through unregistered private placements compared with $154 billion through IPOs, which are registered with the Securities and Exchange Commission.

. . .

Under SEC rules, companies can sell securities without registering them as long as issues are limited to qualified institutional buyers, investors with at least $100 million of assets, and there are no more than 499 stockholders.

By easing the ability to trade through essentially unregulated and unreportable pools of money, Goldman Sachs and the rest of the i-banks are weakening the public equity markets that have served as the foundation for much of the world’s financial systems. While I’m all for creating new exchanges to allow competition to lower trading costs, and I’m all for bringing in new sources of liquidity to fund investments, doing so without the safeguards of public disclosure and oversight is a prescription for disaster. A disaster that we’re already seeing unfold in other markets.

So is Project Turquoise the bearer of doom and destruction to public equity markets? Conversely, will it strengthen equities markets by bringing in new sources of liquidity? Or is it really nothing more than a way to lower trading costs through competition? We’ll know soon. Project Turquoise is scheduled to start trading this month…

• Now we’ve hit crisis proportions!
  Hobbit Crisis: The Shire in Foreclosure
• Citi may be the first to cut a deal with the states over auction-rate securities. Could others follow? And how much will the ultimate settlement be?
  Citi Talks With Regulators May Bring Billions in Buybacks
• In case your dog died, your wife left you, and your truck broke down, Prof. Roubini is here to tell you it’s okay. The rest of the world is going to be doing much, much worse than you:
  Two CNBC Interviews: $2 Trillion of Credit Losses, a Severe Banking and Financial Crisis, a Severe US Recession and a Broader G7 Recession

In less than a month, NYMEX crude oil futures have dropped about 15% in value. Other commodities ranging from precious metals to agriculture have had significant drops as well. Even for the traditionally volatile commodity markets, this is somewhat unusual and has led many people to scratch their heads to figure out what’s happening. Is this simply a pause before the inexorable rise continues? Were there speculators that blew up and are rapidly unwinding their positions? Was there indeed a commodity bubble that has now been pricked? Or are market forces acting the way they’re supposed to, with demand declining as the world’s economies slow down?

Despite the confusion of what exactly is going on in the commodity markets, one point bears mention: no one is worried about what the true value of the September NYMEX CL contract is, or whether the counterparty to their future will be able to deliver as contracted. You can find out the price to the penny, and if you buy and hold a contract, you will get your 1000 barrels of light, sweet crude in Cushing, OK come hell or highwater. In other words, despite an impressive and unexpected 15% drop in a month, the normal market functions of price discovery, liquidity, counterparty guarantees, etc, exist and continue to work fine.

Contrast this with OTC derivatives such as CDO/CDS/MBS securities where the biggest problem has been the lack of a functioning market at all. Much of the turmoil in these markets is not because there are no investors interested in these securities per se as that in the absence of fundamental market infrastructure such as accurate prices, counterparty guarantees, and standardized, easily understood contracts, not even vulture investors want to touch this stuff, even if there might be money to be made.

So why have futures markets survived such volatility while OTC markets have essentially been destroyed? IMHO, it’s not for these reasons:

1. Market size. The notional value of the CDS market has been estimated in the tens of trillions. Far in excess of the notional value of commodity markets. Yet CDSs collapsed while futures haven’t.
2. Liquidity. OTC securities had large dealers and bankers who were contractually obligated to make a market in the securities they created.
3. Leverage. Both OTC securities such as CDOs/MBS/CDSs and futures are highly leveraged.

Thus, I’d argue that there is no reason intrinsic to the nature of either OTC securities or futures that would naturally make one instrument more susceptible to market breakdown than the other.

I would assert that the difference lies soley with the differing regulation of these markets. The regulation and oversight of futures has created a market for highly levered securities that is able to continue to function despite large, rapid, unexpected, and unexplained changes in price (such as we have been seeing this past month). In contrast, OTC security markets collapsed (by which I mean the market itself, not the price) by last year when price declines were less than 15% (remember when it was shocking that some AAA tranches may sell for <95% of par?).

So far, the collapse in oil prices has not required emergent Fed intervention to maintain the stability of the strategically important oil market. In contrast, the collapse of OTC security markets has necessitated the creation of several emergent lending facilities, the bailout of BSC, and now possibly the GSEs. And markets still remain frozen after nearly a trillion dollars of government liquidity and direct intervention.

Stephen Cecchetti made a similar observation last year in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (£3bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM’s exposures were concentrated in thousands of interest-rate swaps.
. . .
The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth’s failure provoked a yawn, while LTCM’s triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

While Amaranth and LTCM were individual firms, I believe Mr. Cecchetti’s observations are generalizable to the behavior of their respective markets as well. Standardized contracts, exchanges, and clearinghouses are three of the primary institutions through which the government regulates and supervises futures trading. They have been successful in maintaining functional markets despite tremendous leverage and volatility. Perhaps it’s time to bring them to the rest of the derivatives world…

According to the Times, U.S. inflation hit a 27 year high in June:

Inflation jumped by 0.8 per cent in the month of June, the most since February 1981, when prices rose by 1.0 per cent, according to the Commerce Department.

Bloomberg reports today that while the Fed will likely keep interest rates unchanged for now, Bernanke is facing a dissenting block of 3 governors who are arguing for more action against inflation.

The fastest inflation in 17 years adds to the risk that three members of the Federal Open Market Committee will dissent for the first time since 1992. Gary Stern, president of the Fed’s Minneapolis bank, and the Philadelphia Fed’s Charles Plosser joined Dallas’s Richard Fisher since the last meeting in June in calling for an increase in rates to limit price increases.

The trio wield more clout than usual because two seats assigned to Fed governors on the 12-member panel are currently vacant.

According to the article, this may result in Bernanke talking tougher about inflation in his official statements.

Personally, I’m a little skeptical that this means much. Talk is cheap. Even Fed-speak. Bernanke has talked tough about inflation ever since he assumed the chairmanship. Yet he has allowed inflation to rise to the current stunning levels. Inflation, even core inflation that excludes food and energy (i.e. the things that have been rising the most in recent years), has consistently exceeded Bernanke’s stated targets, but his actions have been few. While admittedly he is in a tough position right now, his actions in the past year have demonstrated that when push comes to shove, he is willing to sacrifice inflation to pursue other goals, all the while paying lip service to being an inflation hawk.

Furthermore, while 3 governors openly dissenting may have been rare during Greenspan’s term, Bernanke is apparently genuinely interested in fostering open discussion among the governors. From Bloomberg:

Bernanke may be willing to accommodate dissent. Bernanke has praised the Bank of England, whose chief, Mervyn King, has been outvoted twice on rates, as a “leading exponent of increased transparency.”

Bernanke has also opened up FOMC meetings to allow officials to speak out of turn during debates. That means the sessions may resemble the frank exchange of conflicting views common to Bernanke’s discussions during 23 years as an economics professor, said Edward McKelvey, a senior U.S. economist at Goldman Sachs Group Inc.

In 20 FOMC interest-rate decisions as chairman, Bernanke has recorded nine with one dissenting vote and two with a pair of `nays.’ His predecessor, Alan Greenspan, had 17 decisions with one or two dissents in his last 10 years as Fed chief.

Thus, having 3 governors dissenting may not be indicative of all that much more dissent than usual. For any professional Fed-watchers out there: does this really mean there is true dissension in the ranks that might actually force action on inflation that is rapidly approaching the ’70s era we all have nightmares about? Or is this another good P.R. move to appease the inflation hawks with empty words while pursuing other goals?

NYMEX Crude oil futures dipped below $120 today for the first time since May.

Furthermore, Bloomberg reports that “Plunging prices for cocoa, natural gas and sugar are sending the Reuters/Jefferies CRB Index of 19 commodities to it biggest one-day decline since March.”

Bloomberg cites the slowing U.S. economy, rising inventories, and prospects for improved production of various commodities for the broad-based declines.

Of course, commodity trading is highly volatile, and this may just be a slight retrenchment before the march higher resumes, as commodity bulls argue. OTOH, could the commodity bubble be deflating? There must be financial players in the commodity market getting squeezed by their >$20 loss in current crude oil contracts. If the margin calls start coming, we may see further sell-offs…

(Apologies to Yves, but I believe she would have tagged it similarly)

Despite the mounting evidence that the worst financial crisis since the Great Depression was at least exacerbated by the lack of appropriate regulation and oversight in numerous markets ranging from the home mortgage lending to the securitization process to OTC derivatives markets to brokers and banks, Alan Greenspan, in a new commentary in the Financial Times warns against the dangers of too much regulation.

A commentary entitled “Repel the calls to contain competitive markets” contains such choice nuggets of advice to the world’s financial regulators as these:

The economic edifice – market capitalism – that has fostered this expansion is now being pilloried for the pause and partial retrenchment. The cause of our economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship. Regulation, the alleged effective solution to today’s crisis, has never been able to eliminate history’s crises.

This discounts the tremendous amount of regulation and oversight that is required for “market capitalism”, embodied in such institutions as the stock market and private corporations, to function and thrive. Stock markets are one of the most highly regulated and supervised markets in existence.

Furthermore, Mr. Greenspan conveniently ignores that the Great Depression was solved through the government’s fiscal and monetary policies (and of course the greatest government fiscal stimulus: war), rather than market forces. He also ignores that much of the regulatory apparatus in place is specifically designed to combat human nature’s so-called propensity to sway from fear to euphoria and back (including the circuit-breakers instituted in the markets under his watch after the 1987 crash).

Mr. Greenspan then goes on to assert that:

A financial crisis is heralded, in fact defined, by sharp discontinuities of asset prices. The crisis must thus be unanticipated. The fact that risk was heavily underpriced for much of this decade was broadly recognised in the financial community, but the timing of the sharp price correction was nonetheless a surprise.

While it may have been a surprise to Mr. Greenspan and other market boosters, the coming collapse in housing prices, and their long-term unsustainability at current levels was widely discussed. While it was not the majority opinion, it was nevertheless widely held by many respected economists. Mr. Greenspan can admit he was wrong, but here goes further to assert that no one can be right and this is clearly not true.

Despite Mr. Greenspan’s heavy blinders, it is heartening to see that he has finally accepted certain truths:

The credit crunch of the past year has not followed the path of recent economically debilitating episodes characterised by a temporary freezing up of liquidity – 1982, 1989, 1997-8 come to mind. This crisis is different – a once or twice a century event deeply rooted in fears of insolvency of major financial institutions.

In other words, even Mr. Greenspan is finally forced to admit that this is not a liquidity crisis but an insolvency crisis, something that others such as Mr. Roubini have been arguing for at least the past year.

The insolvency crisis will come to an end only as home prices in the US begin to stabilise and clarify the level of equity in homes, the ultimate collateral support for much of the financial world’s mortgage-backed securities.

Does this mean that Mr. Greenspan finally admits that while public and private interventions can ameliorate the declines and slow down the crisis, its ultimate resolution will only come when house prices return to sustainable levels?

So perhaps the cup is half full. Mr. Greenspan is still clearly wedded to his “free market” dogma despite the obvious truth that “free markets” can only exist and thrive within a framework of regulation and supervision. But even he is being forced to admit that the current crisis is fundamentally one of solvency which will only be solved when housing prices decline to sustainable levels.

Maybe after another year of unrelenting bad news and market failures, and another $500 billion in government intervention, Mr. Greenspan will finally be forced to admit the error of his past ways. One can only hope.

Submitted by Lune…

As central banks become more important in dealing with our global financial crises, one important question is how transparent the central banks’ decision-making process should be to the public.

Americans had grown used to the cryptic statements of Mr. Greenspan in his day, and the merest pause or grumble would be solemnly interpreted by semi-professional Greenspan-watchers for the rest of us waiting with bated breath.

When Mr. Bernanke assumed the chair, he promised to open up communications, and make Fed policy and it’s policy-making process more clear. But he learned the power of his words when off-hand remarks to reporter Maria Bartiromo in 2006 caused markets to dive.

While the Fed publishes minutes of previous meetings, other banks, notably the ECB, does not. As a result, in the U.S., we have far more information on the individual voting preferences of each Fed governor, and the dynamics of the meetings in which Fed decisions are made. The ECB is much more of a blackhole.

European politicians, notably Mr. Sarkozy in France, are now calling for greater transparency in the ECB. And he’s joined by several academics. In an article entitled Transparency and Governance in the Euro Zone, Profs. Geraats, Giavazzi, and Wyplosz argue that opening up the ECB to more public inspection would help it accomplish its goals:

The bottom line is that the ECB would find it easier to control inflation by doing more to shape market expectations.¹ Helping markets to anticipate next month’s decision is not enough, because markets care much more about the entire future course of action. The simplest and best way to shape expectations would be for the ECB to publish its anticipated interest rate path.² This would be much more effective than the current approach involving the use of code words. Code words may be misinterpreted and their very imprecision reduces the effectiveness of monetary policy.

Furthermore, they argue that increased transparency would allow for greater public support for ECB policies:

Greater transparency would have another important benefit for the ECB. The only defence for central bank independence in a democracy is popular support. This can be eroded by determined politicians, as evidenced by the declining trust in the ECB among French citizens. Such a development may tempt more politicians to earn popular support by criticizing the ECB, and the repetition of largely misguided attacks may succeed in denting the reputation of the central bank. It should not be so. The solution is better communication, and not just toward financial markets. Better communication, in turn, must rest on a clear strategy and a higher degree of transparency.

Richard Baldwin argues not so fast:

In modern economies central banks don’t control the money supply. Monetary policy works by influencing workers’ and investors’ expectations, as Mike Woodford explains. When it comes to managing expectations, a good communication policy is the biggest wench in the central banker’s toolkit. But, we are still in the trial-and-error phase; research has not identified the optimal communication strategy. As Alan Blinder writes:

Despite the benefits that communication can in principle generate, it is no panacea. Poorly designed or poorly executed communications clearly can do more harm than good; and it is for instance not obvious that a central bank is always better off by saying more. In practice, central banks do limit their communications. In most cases, internal deliberations are kept secret.”

One lesson is clear. More transparency doesn’t help when a central bank speaks with too many conflicting voices–the so-called cacophony problem. More information in this situation confuses rather than enlightens, with negative effects on economic performance. It is hard to think of a group of decision makers that fit this description better than the ECB’s Governing Council.

As the world’s central banks head into uncharted waters, important policy decisions such as the creation of various lending windows, the bailout of Bear Stearns, the proposed support to the GSEs, not to mention sundry decisions such as setting interest rates and inflation targets, virtually require the right of the public to know how these decisions have been made. Yet if much of the power of central banks rests on their ability to present a unified, clear message, then exposing the sausage-making behind that message might weaken the ability of the central banks to lead precisely when their leadership is most required.

Submitted by Lune…

Yves had previously posted about Massachusetts suing Merrill Lynch over auction-rate securities. A new Financial Times post indicates that Citi is in hot water with New York over the same instruments:

Citigroup was on Friday accused of destroying records subpoeaned by Andrew Cuomo, the New York attorney-general, who intends to sue the investment bank for its role in the collapsed auction rate securities market.

Citi “repeatedly and persistently committed fraud” by misrepresenting auction rate securities as safe and cash-equivalent investments, said David Markowitz, chief of the office’s Investor Protection Bureau, in a letter sent to the bank on Friday.

After receiving a subpoena in mid-April for records under New York’s powerful Martin Act, Citi had “destroyed” recordings of related telephone conversations and failed to notify authorities – even though it learnt in mid-June that tapes had been destroyed, the letter claimed.

While the main focus of the article is a dispute over destroyed tapes of phone conversations, the article mentions what the Attorney General intends to pursue as settlement:

Mr Cuomo’s office said any settlement with Citi must include the bank buying back retail investors’ securities at par and paying a “significant penalty”.

A Bloomberg article also adds that New York, along with Texas and Massachusetts have already sued UBS AG, and that the SEC is planning further investigations.

According to Bloomberg, the auction rate securities market was worth $330 billion before its sudden collapse in February. If the stated goal of buying back securities at par with a penalty comes to pass, it looks like the banking industry may be dealing with another large writedown.