Andy Xie, who until last year was Morgan Stanley’s chief Asia economist (he apparently made himself unpopular by being too candid about Singapore), gives a blunt critique of last week’s liquidity infusions by central bankers in “It’s time for central bankers to stop bailing out markets” in the Financial Times.
Xie’s conclusion is that the crisis was caused by speculative leverage; bailing out the perps merely encourages them further. And he also takes issue with the authorities’ fear of recessions, since they have the salutary effect of thinning the herd. While there is nothing particularly novel in his comments, save perhaps his conclusion that the central bank actions will feed an inflationary crisis, it’s a cogent and colorful piece.
Note that some commentators have pointed out that the Fed’s intervention was minor; nevertheless, Brad DeLong observes out that the spike up in the Fed funds rate before the Fed’s move was dramatic.
From the FT:
The global credit bubble is bursting. This bubble is primarily leverage financing for owning risky assets. The people who were responsible for what happened played with other people’s money, marketed arcane financial products with false promises of fat profits, but stuffed their own pockets with big bonuses. Neither these masters of the universe nor their greedy but naïve investors deserve to be bailed out. They deserve what is coming to them.
The central banks bear equal responsibility in the current debacle. After 9/11, central banks cut interest rates dramatically and provided the cheap money for this leverage bubble. They must not flood the world with liquidity again to sustain this bubble or create another. The central banks should focus on price stability, not financial market stability, and should provide liquidity only to contain the multiplier effect of the bubble bursting on the economy.
Nor should central banks stimulate to avoid recession at any cost. Business cycles are not bad. Excesses must be followed with cleansing. The current upturn has lasted extra long due to the stimulative effect of the leverage bubble. After four years of 5 per cent global growth rate, a mild recession is a small price to pay. If, in response to the current crisis, central banks stimulate to pump up growth again, the excesses in the global economy will worsen and make the inevitable correction more painful.
In the past five years, Wall Street has changed dramatically and that may not be for the better. The collapsing agency business has pushed banks into betting their own money for profit and selling “high margin” structured products to their clients. Their eagerness for selling new and poorly understood products, such as sub-prime mortgage derivatives, is a major factor in the current bubble. Like after the junk bond bubble of the 1980s, lawsuits may hit Wall Street for years to come.
Rating agencies should share the guilt. They give high ratings to sub-prime derivatives with high seniority in payment. Unfortunately, the repayment behaviour of the sub-prime borrowers depends on macro conditions. As soon as property prices drop significantly, they tend to default at the same time and the seniority in repayment is not worth much. Like in the previous debt bubbles, rating agencies behave like momentum traders. The ratings are supposed to give guidance to investment risk during bad times, not to be downgraded when the situation turns sour.
The ballooning hedge fund industry is also culpable. As their funds have become big, they have focused on their 2 per cent management fees rather than the share in investment profit. So they have focused on gathering assets by over-promising. Some funds specialise in illiquid assets such as derivative products of sub-prime mortgages. As long as they do not face redemption, they can report whatever performance they want. As soon as redemptions happen, they cannot even sell their stuff and have to refuse withdrawals.
If central banks try to bail out Wall Street, it would lead to high inflation for years. The inflationary effect of loose monetary policy of the past was offset by the deflationary effect of globalisation. Now China and other developing countries are experiencing high and rising inflation. Loose money will go straight into inflation. The vicious cycle of the wage-price spiral of the 1970s has not occurred as both labour and capital still believe in the inflation-fighting credibility of the central banks. If they loosen up again to bail out Wall Street, this credibility may be squandered. The ensuing wage-price spiral could ruin the global economy for years to come.
What is occurring is an opportunity for central banks to restore their credibility. Markets have been taking more risk than they should because they believe that central banks will come to their aid during times of crisis, like now. The penchant of Alan Greenspan, former US Federal Reserve chairman, to flood the market with liquidity during financial instability is the genesis of this “central bank put”. As long as this expectation remains, financial bubbles will occur again and again. Now is the time to act. Let the crooks go bankrupt. Central banks should bury the Greenspan “put” for good.
Hey, wait a minute – I thought it was simply ordinary open market operations to maintain the target rate!! A bailout? No, really?
While I did not use the word “bail out,” the intervention by the ECB went beyond ordinary open market operations. They made funding available on an open-ended basis at a non-penalty rate.
The focus of worry was institutions who were suspected of using commercial paper to fund asset-backed commercial paper, some (much?) of which had subprime exposure.
Now IMHO, borrowing short-term to invest in risky assets is a dumb strategy. One can take the position that institutions that engage in misguided investment strategies ought to have their heads handed to them. But in this case, the collateral damage was to the payment system, a crucial facility that could not be permitted to fail.
Hence, while I did not use the term “bail-out” one can make an argument that that is indeed what happened. The fact that the operations have ceased is not the point. The ECB, the Fed, and the BOJ (among others) have made it clear they will intervene again if needed.
fwiw, xie had another rather lengthy but good article recently…
“Economics has an efficient wage theory. Its name misrepresents its content. It says that a person should be paid above market if his position allows him to do a lot of damage. For example, if a pilot slackens, he could kill a lot of people. Hence, the market wants to overpay him to keep him focused. A similar person who drives a truck can do less damage and is less well paid. In financial industry, if a person makes one mistake, he could cause losses of hundreds of millions to his clients. Hence, his clients want to pay him above market just to encourage him not to make mistakes. This efficiency wage theory applies to CEO’s too. Most CEO’s I have come across are not very capable but are very well paid. They mostly ride the momentum and go with the flow. Because their bad decisions can destroy so much, the market wants to give them enormous incentives not to make mistakes. Still, so many of them destroy their companies anyway. Efficiency wage is really a bribe. But, bribes don’t always work…”
“The LBO market is almost non-existent in China. China doesn’t have a sophisticated bond market to fund such transactions. Most businesses in China don’t have cash flow stable enough to make the debt game viable. Hence, the core expertise of most PE houses is not applicable in China.
“What China needs is VC for traditional industries. Three forces that drive China’s economy are industrialization, urbanization, and globalization. On the supply side, it is about creating businesses that meet the daily needs of households and businesses. It is like the West one hundred years ago. Because traditional industries have been stable businesses in the west, they are targets for LBO’s. In China, they are new and growth businesses. There are merely 1,500 companies listed in Shanghai and Shenzhen and many of them should be de-listed due to bad quality. In contrast, the US market has about 10,000 companies listed. China has too few good companies…”
any idea what Andy Xie is up to nowadays? which house is he with? maybe he’s speaking from position …
Today morning I saw on CNBC, Andy being introduced as independent economist seems he is not yet affliated to any house/co
I agree that the bailout meme is, once again, getting out of hand. Losses incurred by those holding bonds backed by junk mortgages will not disappear even if the Fed cuts rates. The same applies to the LCTM debacle and the tech bubble (the Nasdaq is still 50% below peak).
Rather, it’s once again time to trot out the old debate on whether asset prices should be part of monetary policy. An argument can be made that if the Fed had taken into account house prices, rates wouldn’t have stayed so low for so long.