China and US deficits

It is estimated that more than two-thirds of the Chinese Central Bank’s $1.95 trillion in foreign exchange reserves are believed to be in American securities, with the rest in assets denominated in euros, yen and other currencies. Some other estimates puts its holdings of the US debt papers at $1.7 trillion. But recent trends indicate that these purchases, which have for so long financed the massive US current account deficits, besides contributing to keeping the US Dollar strong, may be waning.



Brad Setser, though, feels that instead of declining, the accumulation of foreign holdings may have stabilized.



It is now well acknowledged that the macroeconomic imbalances generated over the past two decades in the world economy, by way of the currency manipulation by Central Banks, "savings glut" and exports generated foreign exchange reserves of emerging economies and the consumption driven imports surge in the US fuelled by the "wealth effect" unleashed by successive asset bubbles, has been a major contributor to the ongoing economic crisis.

After the crisis broke out, the spectacularly swift de-leveraging of their positions in emerging economies by the Wall Street firms and the flight to the relative safety and liquidity of US dollar denominated assets by private investors across the world have had the effect of shoring up the beleaguered dollar, sustaining the huge US current account deficits, and keeping interest rates low.

More financial market regulation proposals

Interesting debate between Mark Thoma and Houman Shadab about the types and extent of regulation of financial markets. While most of the suggestions are already under circulation, the debate is worth a revisit.

Mark Thoma draws attention to Robert Lucas' concerns of systemic risk spreading from the possible regulatory arbitrage if the shadow banking system is not adequately regulated. However, Houman Shadab disagrees with the excessive concern with regulating the hedge funds and CDSs in the shadow banking system, and claims that it is more important to make "sure that regulated companies like banks do not take on excessive risks through their relationships with lightly regulated entities like hedge funds or by using instruments such as derivatives".

Mark Thoma echoes the concern raised by Andrew Lo about the possibility of large amounts of pension money flowing into hedge funds in the future, as they seek to reallocate their portfolios so as to recoup atleast some part of the massive lossess suffered by them during the meltdown. This makes it all the more important to regulate the institutions like hedge funds in the shadow banking system.

In light of the critical role played by the "too big to fail" institutions in amplifying the financial market crisis, Mark Thoma proposes putting in place measures to quantify the risks arising from the market or monopoly power or connectedness of firms. One of the suggestions is to use measures like the Herfindahl-Hirschman Index, which is a measure of the size of firms in relation to the industry and is an indicator of the amount of competition among them. Regulators can constantly monitor such indices and if they cross a threshold level, they should step in with further actions. The level of leverage is another important regulatory parameter that should be monitored.

Mark Thoma drives home the importance of system wide regulation, and the need for regulators to be one step ahead, to the extent possible, instead of being one step behind as they have been in the past. He also writes, "The level of regulation a firm or industry faces should match the size of the underlying threat. And for me, that means powerful firms need to be met with more powerful regulators — or, even better, that these firms need to have limits on how large and powerful they can become." Houman Shadab feels that it may be impossible to appropriately monitor and regulate hedge fund risks.

In light of ample evidence about excessive risk taking despite the awareness of the dangers posed, Shadab feels that "giving regulators more responsibility by broadening the kinds of companies they must look after seems to make little sense. Instead, we should be encouraging far more aggressive private risk management by the parties that got duped by Wall Street. But the more these investors rely on regulators or others to monitor risk instead of doing their own due diligence, research, and risk-management, the more complacent they’ll become. Investors tend to keep a closer eye on risk when they know they can’t rely on third parties to do the dirty work for them."

The crisis has also triggered off an intense debate about how much risk banks should bear in light of the events of recent past. Noted economists like Paul Krugman have called for ushering in an era that makes banking boring, limiting their mandate to take risks, Amar Bhide has called for an age of "primitive finance", which would mean greatly limiting what commercial banks are allowed to do, and reviving a more stringent version of the Glass Steagall Act.

Laurence Kotlikoff has called for "limited purpose banking" (and here), where commercial banks would initiate only AAA-rated mortgages and business loans (approved and rated by the government, rather than by private ratings agencies), and then bundle and sell those loans within mutual funds.

Update 1
Mark Thoma points to two regulatory mistakes that led us to this crisis - the deregulation movement of the nineties had fostered an evangelical belief that markets are self-regulating, even self-repairing; and the decreased vigilance on macroeconomic stability, arising from the economic stability of the "Great Moderation" era on eighties and nineties that gave rise to a belief that major economic crashes are a thing of the past.

Houman Shadab outlines three principles of financial sector regulation.

Update 2
Simon Johnson has come out vehemently in support of using anti-trust legislation to break up the "too big to fail" institutions so as to contain the systemic threats of such large financial institutions.

Update 3
Vox has an article summarizing methods outlined in a recent IMF paper to identify systemic risks in banking sector.

Update 4
Economix points to Ben Bernanke's vision of futire financial market regulation. He talked about the need for a new "consolidated supervision" framework in this new "macroprudential" approach to supervision:

• Monitoring large or rapidly increasing exposures — like to subprime mortgages — across firms and markets, rather than only at the level of individual firms or sectors.
• Assessing the potential systemic risks implied by evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products.
• Analyzing possible spillovers between financial firms or between firms and markets, like the mutual exposures of highly interconnected firms.
• Ensuring that each systemically important firm receives oversight commensurate with the risks that its failure would pose to the financial system.
• Providing a resolution mechanism to safely wind down failing, systemically important institutions.
• Ensuring that the critical financial infrastructure, including the institutions that support trading, payments, clearing, and settlement, is robust.
• Working to mitigate procyclical features of capital regulation and other rules and standards.
• And identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole.

Update 5
Pew report on principles of financial reforms is available here. The abstract of ICMB-CEPR report on financial reforms is here.

Peer effects and poverty on school and life outcomes

There have been a number of recent studies, most notably by Nobel laureate and Chicago Professor James Heckman, which brings to focus the importance of parental care, peer effects, and societal environment on children during their formative years. Many of these studies have been spurred on by a raging debate in the US about the reasons for the falling education standards and skill levels in the country. The initial findings from these studies have importance for all societies.

Stressing the importance of strong family ties and how ability gaps open up early in life, Prof Heckman writes (full paper here), "Dysfunctional families retard the formation of the abilities needed for successful performance in modern society". The foundation for this claim is the substantial body of evidence that highlights the importance of non-cognitive skills (as opposed to cognitive test scores) like motivation, sociability, the ability to work with others, the ability to focus on tasks, self-regulation, self-esteem, time preference, health, and mental health. Prof Heckman compares such skills to the old-fashioned "character", and attributes their development to the early environment in which the chiold is brought up.

A substantial body of research shows that earnings, employment, labour force experience, college attendance, teenage pregnancy, participation in risky activities, compliance with health protocols, and participation in crime are all strongly affected by non-cognitive as well as cognitive abilities.

Dismissing genetic determinism of the "Bell Curve" school, he writes, "Gaps in ability emerge early and persist. Most of the gaps in ability at age 18, which substantially explain gaps in adult outcomes, are present at age five. Schooling plays a minor role in creating or perpetuating gaps, even though American children go to very different schools depending on their family backgrounds. Test scores for children with very different family backgrounds are remarkably parallel with age... A substantial literature shows that family environments play an independent role in creating adult abilities. Adverse family environments of children create problem adults."

Fifty percent of the variance in inequality in lifetime earnings is determined by age 18. The family plays a powerful role in shaping adult outcomes that is not fully recognised by current American policies. As programs are currently configured, interventions early in the lives of disadvantaged children have substantially higher economic returns than later interventions such as reduced pupil-teacher ratios, public job training programs, convict rehabilitation programs, adult literacy programs, tuition subsidies, or expenditure on police. This is because "life-cycle skill formation is dynamic in nature. Skill begets skill; motivation begets motivation. Motivation cross-fosters skill, and skill cross-fosters motivation. If a child is not motivated to learn and engage early on in life, the more likely it is that when the child becomes an adult, he or she will fail in social and economic life. The longer society waits to intervene in the life cycle of a disadvantaged child, the more costly it is to remediate disadvantage."

Scott Carrell and Mark Hoekstra claim, in an NBER working paper, "that children from troubled families significantly decrease their peers' reading and math test scores and significantly increase misbehavior of others in the classroom. The effects are heterogeneous across income, race, and gender and appear to work primarily through troubled boys".

The Economist draws attention to the work of Martha Farah of the University of Pennsylvania who showed that the working memories (the ability to hold bits of information in the brain for current use - entry into working memory is a prerequisite for something to be learnt permanently) of children who have been raised in poverty have smaller capacities than those of middle-class children. Gary Evans and Michelle Schamberg (full paper here or here) have in a recent paper, based on a long term study, claimed that the reduced capacity of the memories of the poor is almost certainly the result of stress affecting the way that childish brains develop.

They find that stress changes the activity of neurotransmitters, the chemicals that carry signals from one nerve cell to another in the brain; suppresses the generation of new nerve cells in the brain, and causes the "remodelling" of existing ones; and shrinks the volume of the prefrontal cortex and the hippocampus. Therefore, as The Economist writes, children with stressed lives find it harder to learn, do less well at school, end up poor as adults and often visit the same circumstances on their own children.

Orphaned month and Wall Street accounting - old habits die hard?

Old habits die hard, even after a near-death experience! It now appears that there may have been more to Goldman Sachs' strong $1.66 bn profit for the first quarter of the year, as reports emerge of doctored accounts and other practices that characterised Wall Street accounting in its halcyon days early this decade.

Barry Ritholtz points to an orphaned December month and receipts from AIG transfer payments as being responsible for the strong financial result for the quarter. In the guise of shifting their accounting calendar from December-February format to the regular calendar quarter, Goldman have omitted December 2008 from both its prveious and present quarterly results, and also pushed lots of write-offs into the December month. The quarterly results were also bloated up by its share of the receipts from the transfer payments of the bailout money given to AIG.

And this is not all, it also appears that Goldman may have unfairly benefitted from the tax payer bailout of AIG. It emerges that Goldman had already "hedged" against a possible credit loss from their CDS with AIG, and were able to collect on that hedge (no matter what it was). Despite this, and possibly suppressing the information (or the TARP administrators and regulators overlooking it), Goldman also benefitted from its share of the transfer payments from the bailout money awarded to AIG to shore up its clients. As Karl Denninger writes, "It appears Goldman got paid twice for the same risk and the second payment came straight out of the taxpayer's hide".

And as Floyd Norris points out, apart from the $10 bn of TARP money, Goldman also received blanket government guarantee for about $28 bn of FDIC backed bonds it issued in the market. While Goldman is ready to return the $10 bn of conditions attached TARP money, it is quietly holding on to other forms of public support that come with virtually no strings attached.



Another disturbing issue was inadvertantly raised by Goldman CFO, when he grudgingly attributed the profits to the fact that "many of our traditional competitors have retreated from the marketplace". As James Kwak writes, if this is true, then oligopoly profits have gone up, making "the big banks even more powerful than they were before the crisis".

It also appears that Goldman may not be the only one to indulge in accounting tricks, as the news trickling in from Wells Fargo seems to indicate. Andrew Leonard too thinks much the same here. The "green shoots" in the landscape may only be the magic of Wall Street accountants, as they seek to inflate their bottom-lines to avoid complying with the TARO conditions! When will they learn?

Update 1
More skeletons form the Goldman cupboard. An NYT op-ed asks disturbing questions about Hank Paulson's role in liquiating Goldman's competitors and bailing out AIG, all of which coincidentally (or is it mere coincidence?) has had the effect of benefitting Goldman enormously. The op-ed writes,

"How can one ignore the crucial role that Henry Paulson played in the decisions to shutter Bear Stearns, to force Lehman Brothers to file for bankruptcy and to insist that Bank of America buy Merrill Lynch at an inflated price? David Viniar, Goldman’s chief financial officer, acknowledged in a conference call yesterday the important role the changed competitive landscape had on Goldman’s unexpected first-quarter profit of $1.8 billion: 'Many of our traditional competitors have retreated from the marketplace, either due to financial distress, mergers or shift in strategic priorities'...

But he was largely mum on American International Group, which, Goldman’s critics insist, is the canvas upon which the bank and its alumni have painted their great masterpiece of self-interest. A few days after Mr. Paulson refused to save Lehman Brothers last September — at a cost of a mere $45 billion or so — he came to A.I.G.’s rescue, to the tune of $170 billion and rising. Then he decided to install Edward Liddy — a former Goldman Sachs board member — as A.I.G.’s chief executive. Goldman has since received some $13 billion in cash, collateral and other payouts from A.I.G. — that is, from taxpayers."

Goldman's long track record of expert manipulation of the levers of power in Washington reminds of Reliance's path to business glory in India!

Update 2
More skeletons form the Goldman cupboard. It is revealed that AIG chief and former Goldman Board Director, Edward Liddy, continues to own singificant stake in Goldman Sachs. This raises serious questions about the propriety of AIG's action in making good the CDS issued by them to Goldman, from government bailout money, despite the fact that Goldman had already hedged against its losses. Andrew Leonard too weighs in.

On macro-prudential regulation

Vox carries an informative article explaining the concept of macro-prudential regulation, with its focus on "system-wide orientation of regulatory and supervisory frameworks and their link to the macroeconomy". Claudio Borio defines two characteristics of such regulation - (a) it focuses on the financial system as a whole, with the objective of limiting the macroeconomic costs of episodes of financial distress; (b) it treats aggregate risk as dependent on the collective behaviour of financial institutions (or "endogenous"), in contrast to how individual agents treat it (exogenous).

He writes that the macroprudential approach consists of two dimensions - "cross-sectional dimension" (distribution of risk in the financial system at a given point of time) and "time dimension (evolution of aggregate risk over time). He writes,

"The key issue in the cross-sectional dimension is how to deal with common (correlated) exposures across financial institutions. These arise either because institutions are directly exposed to the same or similar asset classes or because of indirect exposures associated with linkages among them (e.g. counterparty relationships). Common exposures are critical because they explain why institutions can fail together... macroprudential regulator would focus on the joint failure of institutions, which determines the loss for the financial system as a whole. The main policy question is how to design the prudential framework to limit the risk of losses on a significant portion of the overall financial system and hence its 'tail risk'.

The key issue in the time dimension is how system-wide risk can be amplified by interactions within the financial system as well as between the financial system and the real economy. This is what pro-cyclicality is all about. Feedback effects – the endogenous nature of aggregate risk – are of the essence. During expansions, declining risk perceptions, rising risk tolerance, weakening financing constraints, rising leverage, higher market liquidity, booming asset prices, and growing expenditures mutually reinforce each other, potentially leading to the overextension of balance sheets. The reverse process operates more rapidly, as financial strains emerge, amplifying financial distress. As a result, actions that are rational and compelling for individual economic agents may result in undesirable aggregate outcomes, destabilising the whole system. The main policy question is how to dampen the inherent pro-cyclicality of the financial system."

And on the way ahead with regulation in these two aforementioned dimensions, he writes,

"In the cross-sectional dimension, the guiding principle for the calibration of prudential tools is to tailor them to the individual institutions’ contribution to system-wide risk. Ideally, this would be done in a top-down way. One would start from a measure of system-wide tail risk, calculate the contribution of each institution to it and then adjust the tools (capital requirements, insurance premia, etc.) accordingly. This would imply having tighter standards for institutions whose contribution is larger, contrasting sharply with the microprudential approach, which would have common standards for all regulated institutions. In turn, that contribution will depend on features that are either specific to the institution itself (e.g., its size and probability of failure) or relevant for the system as a whole (its direct and indirect common exposures with other institutions).

In the time dimension, the guiding principle is to calibrate policy tools so as to encourage the build-up of buffers in good times so that they can be drawn down as strains materialise. By allowing the system to absorb the shock better, this would help to limit the costs of incipient financial distress. Moreover, the build-up of the buffers, to the extent that it acted as a kind of dragging anchor or 'soft' speed limit, could also help to restrain the build-up of risk-taking during the expansion phase. As a result, it would also limit the risk of financial distress in the first place."

Peru's high-noon of democracy and rule of law?

Last week, in a less publicised event, a three judge panel of the Peruvian Supreme Court convicted former President Alberto Fujimori to 25 years in jail for human rights abuses, including the killing of 25 people by a military death squad and series of kidnappings and murders.

The charges against Mr Fujimori revolve around the counter-insurgency methods used by his government during his 10-year presidency, from 1990 to 2000, to successfully combat and eliminate the decades long insurgency by two Maoist guerrilla groups - the Shining Path Movement and the Túpac Amaru Revolutionary Movement. The conviction marks the culmination of a fiteen month long trial, that climaxed with Alberto Fujimori becoming the first democratically elected President to be tried and convicted in his own state.

The poignancy in the outcome cannot be missed, and is an enduring dimension in the debate surrounding governance and rule of law when administering civil strife or terrorist militancy prone polities. On the one hand, the conviction is a triumph of judicial oversight and rule of law, a testimony to the strength of Peru's fledgling democracy and its institutions. One the other hand, one cannot but wonder whether Fujimori, who did more than anyone else to bring a corrupt, civil war and hyper-inflation prone Latin American backwater to today being one of the most democratic, politically stable, and economically vibrant countries in the region, deserved better.

The Fujimori verdict should spotlight attention on similar examples of well-documented and widely acknowledged instances of human rights violations in counter-insurgency and counter-terrorism operations by governments and their functionaries across the world, including in and by accomplished democracies. Are the institutions of democracy in these leaders of the free world not strong enough to bite the bullet? Or are the opinion-makers and the establishment in these countries living in a state of self-denial?

American tax system debate - progressive or not?

Economix presents two graphics that clearly indicates that, contrary to interpretations of the latest CBO estimates (full paper here), the US taxation system is far from being progressive.



Horizontal axis shows the income group. Vertical axis shows the percentage of income that the average member of that group pays in taxes. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends (but not government transfers).



Horizontal axis shows the income group. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

It is pertinent to remind ourselves that a taxation system is loosely considered progressive if the "rich pay more taxes than the poor". The last phrase has been interpreted, both statistically and gramatically, by different sides to validate their claims. However, given the vast and ever widening disparities in income, conventional interpretations of the phrase which center on the shares of the income paid as taxes and/or the taxes paid, may be misleading.

As Lane Kenworthy (summary here and here) has argued very convincingly, it is important that all judgements of the taxation system be made only after including all the different types of taxes - federal, state and local - and all the sources of income, both market income and government transfers. All these taken together, and as the graphics above clearly indicates, the US taxation system is relatively flat and not progressive.

The Economix has been running a series of posts on this issue here, here and here.

Update 1
Robert Reich dispels some of the common American tax myths here.

Update 2
Freakonomics feels that the numerous deductions and tax breaks not available in other countries ensures that the effective corporate income taxes in the US — the tax rates companies actually pay — are among the lowest in the developed world.

Update 3
Economix (see also here on the relative sources of incomes for the rich and richest Americans) points that the richest Americans pay a lower share of their incomes in taxes than the nearly richest Americans, mainly due to the lower rate on capital gains (which is the increasingly major source of income for the richest Americans) tax.



IRS figures show that once a taxpayer earns about $2 million in annual income, the effective tax rate starts to fall. Americans earning more than $10 million a year, for example, pay an effective income tax rate of 19.7 percent on average, whereas those making $500,000 to $1 million a year pay an effective tax rate of 23.4 percent.

Update 4 (29/6/2010)
See these excellent graphics on the impact of various taxes on the different percentiles.

Update 5 (24/4/2011)

Paul Krugman points to the fact that the share of the total taxes paid by all income groups were similar to their incomes themselves, thereby raising doubts about the progressivity of US taxation.



Update 6 (22/9/2011)

Paul Krugman uses data from CBO for 1979-2005 to estimate the impact of change in taxes on the after tax incomes of people at different income percentiles. Changes in tax rates have strongly favored the very, very rich.