Tuesday, March 24, 2009

Mundell on who and what caused the crisis and the way out

Dani Rodrik points attention to an excellent and informative presentation given by Robert Mundell on the financial crisis and the international monetary system. Prof Mundell touches on several interesting and controversial issues like the role of soaring dollar, decision to let Lehman fail, dated spending vouchers, nationalization, euro-dollar currency system, a global lender of last resort, global currency etc.

1. The soaring dollar (the dollar appreciation overvalued US dollar assets including all fixed income securities and mortgages, tipping Lehman Bros and other banks over the edge) and falling gold price in August-September 2008, were symptoms of a shortage of tight money (despite the low interest rates) and dollar liquidity. "Had the FED recognized this shortage and bought foreign exchange to prevent the appreciation, there would probably have been no financial crisis in the fall. The Federal Reserve cut off the economic recovery in 2008(2) and tipped the economy into recession and financial crisis".

2. He claims that there was a recovery in the second half of 2008 in the US, with growth of 2.8%, which was nipped off by the policies of the government and the Fed. The decision to let Lehman fail exacerbated the crisis, greatly increasing the demand for money further, creating the casualties that followed. The failire to effectively intervene to stem the rise of dollar exacerbated the liquidity squeeze.

3. The five goats that caused the crisis
a) Lewis Ranieri - the bond trader who is credited to be the "father of securitized mortgages"
b) Bill Clinton - for repealing the Glass-Steagal Act, "prompting the era of the superbank and primed the sub-prime pump" and liberalizing the norms for mortgage lending.
c) Alan Greenspan - for keeping interest rates too low, dollar too weak, for too long, leading the housing bubble to develop; supporting sub-prime lending and variable rate mortgages; and defending derivatives.
d) Maurice Greenberg (AIG founder) - for conducting vast business in credit default
swaps (CDS) and mass multiples of derivatives.
e) Ben Bernanake - for allowing dollar to soar as the euro fell from above $1.60 in June to below $1.30 in October 08 and failing to appreciate that this appreciation would freeze the credit markets causing extreme shortage of dollar liquidity.
f) Hank Paulson - for letting Lehman fail and failing to recognize the consequences of dollar appreciation.

4. The five "trouble makers" were - securitization of mortgages (cut link between issuers and holders); derivatives (created new systemic risks);Credit-Default-Swaps (enabled insurance without ownership); Mark-to-Market Accounting Rules (created intertemporal instability in balance sheets); and Variable Rate Mortgages

5. He gives six prescriptions for the crisis
a) Issue $500 bn Dated Spending Vouchers (to expire in 3 months) to increase effective demand. Retailers would use the executed vouchers as tax credits.
b) Cut corporation tax rates from 35% to 15% to allow recapitalization of corporations and increase competitiveness.
c) Government takeover and restructuring of insolvent banks for subsequent privatization to rehabilitate the banking system.
d) Stabilize dollar-euro rate with the euro fixed at limits between $1.20 and $1.40 to avoid beggar-thy-neighbor exchange rate opportunism. The stabilization can be done gradually by creating a band of fluctuation at the margins of which the banks intervene and then narrow the band as the FRB and ECB get more comfortable at coordinating monetary policies. The dollar-euro rate to be the new anchor for the international monetary system around which an international currency can be based.
e) Establish an International Macroeconomic Advisory Council as a global version of the Volcker-Chaired Obama Advisory Council to deal with the coordination of international macroeconomic policies.
f) Issue 1 Trillion SDRS to IMF members in proportion to quotas or according to a new formula introduced to distribute the seigniorage more equitably. This would provide public money to especially the smaller countries who do not have a lender of last resort. It would also prevent the collapse of the banking systems in the rest of the world.

6. He advocates a global currency, if need be among the Asian economies, as the long run goal. He also prefers a single unit for quoting prices on major commodities, a common unit for denominating debts, a common rate of inflation for participating countries, a common interest rate on risk-free assets, and a global business cycle.

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