How Much Will Currency Policies Really Affect Our Economy?

Oct 6, 2010J. W. Mason

downarrow-money-150Does the math really add up on these potential solutions to our economic problems?

downarrow-money-150Does the math really add up on these potential solutions to our economic problems?

A number of economists of the liberal Keynesian persuasion have been arguing recently that dollar devaluation is an important step in moving us back toward full employment. In principle, of course, a cheaper dollar should raise US exports and lower US imports. But what's missing from many of these arguments is a concrete, quantitative analysis of how much a lower dollar would raise demand for American goods.

In the interest of starting a discussion, here is a very rough first cut. There are four parameters to worry about, two each for imports and exports: how much a given change in the dollar moves prices in the destination country (the passthrough rate), and how much demand for traded goods responds to a change in price (the price elasticity). We can't observe these relationships directly, of course, so we have to estimate them based on historical data on trade flows and exchange rates. But once we assign values to them, it's straightforward how to calculate the effect of a given exchange rate change. And the values reported in published studies suggest that the level of the dollar is a relatively minor factor in US unemployment.

For passthrough, estimates are quite consistent that dollar changes are passed through more or less one for one to US export prices, but considerably less to US import prices. (In other words, US exporters set prices based solely on domestic costs, but exporters to the US "price to market".) The OECD's global macro model uses a value of 0.33 for import passthrough at a two-year horizon; a simple OLS regression of changes in import prices on the trade-weighted exchange rate yields basically the same value. Estimates of import price elasticity are almost always less than unity. Here are a few: Kwack et al (2007), -0.93; Crane, Crowley and Quayyum (2007), -0.47 to -0.63; Mann and Plück (2005), -0.28; Marquez (1990), -0.63 to -0.92. (Studies that use the real exchange rate rather than import prices generally find import elasticities between -0.1 and -0.25, which is consistent with a passthrough rate of about one-third.) So a reasonable assumption for import price elasticity would be about -0.75; there is no support for a value beyond -1. Estimated export elasticities vary more widely, but most fall between -0.5 and -1.

So let's use values near the midpoint of the published estimates. Let's assume import passthrough of 0.33, import price elasticity of -0.75, export passthrough of 1 and price elasticity of -1. And let's assume initial trade flows at their average levels of the 2000s -- imports of 15 percent of GDP and exports at 10.5 percent of GDP. Given those assumptions, what happens if the dollar falls by 20 percent? The answer is, the US trade deficit shrinks by 1.9 percent of GDP.

That might sound like a lot. But keep in mind, these are long-run elasticities -- in general, it takes as much as two years for price movements to have their full effect on trade. And the fall in the dollar also can't happen overnight, at least not without severe disruptions to financial markets. So we are talking about an annual boost to demand of somewhere between 0.5 and 1.0 percent of GDP for two to three years. And then, of course, the stimulus ends unless the dollar keeps falling. This is less than half the size of the stimulus passed last January. (Although to be fair, increased demand for tradables should have a higher multiplier than the mix of direct spending, transfers and tax cuts that made up the Obama stimulus.) The employment effect would probably be of the same magnitude -- a reduction of the unemployment rate by between 0.5 and 1.0 points.

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So it's not a trivial effect, but it's also not the main thing we should be worried about if we want to get back to broadly-shared prosperity. We should remember, too, that a policy of boosting US demand by increasing net exports has costs that a policy of boosting domestic demand does not.

And what about China? At least as often as we hear calls for a lower dollar, we hear calls for China to allow its currency to rise. How much could that help?

Unfortunately, there aren't as many good recent studies of bilateral trade elasticities between the US and China. And the BEA's published series for Chinese import prices only goes back to 2003, which isn't enough for reliable estimates. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn't affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is an implausibly high 1.5; then a 20 percent appreciation of the Chinese currency only provides a boost to US demand of less than one half of one percent of GDP in total, spread out over several years.

And of course, those are all wildly optimistic assumptions. A recent Deutsche Bank report uses an estimate of -0.6 for the exchange rate elasticity of Chinese exports. They don't give any estimates for US-China flows specifically, but given the well-established empirical fact that US imports are unusually exchange-rate inelastic, we have to assume that the number for Chinese exports to the US is substantially smaller than for Chinese exports overall. Consistent with that, my own simple error-correction model, using 1993-2010 data and the relative CPI-deflated bilateral exchange rate, gives an exchange rate elasticity of US imports from China of -0.17. If the real figure is in that range, then a Chinese appreciation of 20 percent will reduce our imports from China by just 0.03 percent of GDP -- and of course much of even that tiny demand shift will be to goods from other low-wage exporters. This last point makes a focus on the Chinese peg particularly problematic as an explanation of US unemployment. If you are talking about reducing the value of the dollar against our trading partners as a whole, any resulting shift away from imports has to be to domestic goods. But presumably the closest substitutes for Chinese imports are usually other imports, not stuff made in the USA.

These are rough calculations and only intended to start a conversation. But it's a conversation we very much need to have. Before we launch a trade war with China for the sake of American workers, we need more concrete answers on the size of the potential gains.

Historically-minded critics of China and other surplus countries often quote Keynes' writings from the 1930s and '40s, with their emphasis on the importance of "creditor adjustment". The implication is that it's China's responsibility to reduce its net exports. But this is a misleading reading of Keynes. In fact, his concern was only ever to ensure that no country was prevented from pursuing full employment by the need to earn foreign exchange. The US, as the supplier of the world reserve currency, cannot face a balance of payments constraint; if we fail to pursue full employment, we have no one to blame but ourselves. If Keynes were alive today, I suspect he would be telling American policymakers to forget about China and focus all their efforts on boosting US demand -- by public investment in infrastructure, by unconventional monetary stimulus, by paying people to dig holes and fill them up again if need be. Because he knew that the only reason to worry about the trade balance was to gain the freedom to pursue "a policy of an autonomous rate of interest, unimpeded by international preoccupations, and of a national investment program directed to the optimum level of domestic employment, which is twice blessed in the sense that it helps ourselves and our neighbors at the same time."

J. W. Mason is a graduate student in economics at the University of Massachusetts, Amherst. A version of this post previously appeared at The Slack Wire.

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Main Street is Dying a Death by a Thousand Spending Cuts

Oct 5, 2010Marshall Auerback

marshall-auerback-100The evidence is everywhere that fiscal austerity only prolongs our misery.

marshall-auerback-100The evidence is everywhere that fiscal austerity only prolongs our misery.

According to the in an article entitled "Savers told to stop moaning and start spending," Charles Bean, deputy governor of the Bank of England, said, "Savers shouldn't necessarily expect to be able to live just off their income in times when interest rates are low. It may make sense for them to eat into their capital a bit." Mr. Bean also said savers "might be suffering" from the low bank rate, but they had done well from higher rates in the past and would do so again. Encouraging Britons to spend was one reason why the Bank had cut interest rates, he added.

Spend what exactly, Mr. Bean? Why is it that central bankers find it easy to recall the following equation: C (consumption) + I (investment) + G (gov't spending) = GDP (gross domestic product), but they can't seem to learn this one: HU (high unemployment) + HD (high debt levels) + 0 (no interest income) = AZS (almost zero spending).

I know why: because the latter depends on fiscal policy, and central bankers consistently agitate against fiscal policy. This continues despite the fact that expansionary government spending by accounting identity helps to sustain the private sector desire to save. Unfortunately, Charles Bean of the Bank of England fails to understand that today's predisposition to save is a natural reaction to the credit binge that preceded the crisis. Had the increased private sector saving that occurred over the past few years not been accommodated by rising deficits, then the negative income adjustments would have been more severe and the private sector's plans to return some safety margin to their balance sheet positions would have been thwarted. But he and his fellow central bankers appear incapable of acknowledging this fact.

Each week new evidence emerges that categorically demonstrates that the fiscal austerity proponents are clueless about the functioning of real economies and monetary systems. So today in Britain we have a new government committed to significant budget cuts, despite mounting evidence that cuts already undertaken are drastically curtailing their economic activity. The recently released Markit/CIPS UK Manufacturing Purchasing Managers' Indices, which is calculated from data on new orders, output, employment, supplier performance and stocks of purchases, fell to a ten-month low of 53.4 in September, down from a revised figure of 53.7 in August. Similarly, Ireland finds itself in the midst of a major banking crisis -- Anglo-Irish Bank was recently nationalized, for example -- despite the fact that the Irish government has steadfastly continued to apply the fiscal austerian measures urged on it by the ECB. In reality, this is because of the austerity measures it is taking. The budget deficit, as a percentage of GDP, now stands at 32 percent! Those are wartime-type levels of expenditures.

Yet the conditions attached to the European Central Bank's ongoing financial support of Ireland and the rest of the euro zone is continued fiscal austerity. The so-called PIIGS nations remained trapped between Scylla and Charybdis as a consequence of this Faustian bargain with the European Central Bank. If the ECB stops buying national government debt on the secondary markets, those governments are likely to default, and the big French and German banks it is protecting will be in crisis. Alternatively, every day governments like Ireland or Portugal continue with this policy, the more their economies continue to implode. Ultimately there will be mayhem. The euro itself could once again be threatened.

Don't get us wrong: we think such deficits ultimately put a floor on demand and will help the economy recover. But policy makers need to let these economies breathe for a time, rather than crushing them with additional threats of fiscal austerity. Isn't it interesting that the very policy prescriptions designed to eliminate the so-called "scourge of public debt" are actually increasing it? Shouldn't that make our policy makers pause in their enthusiastic embrace of fiscal austerity? Even the high priests of austerianism, the International Monetary Fund, are now conceding in their latest report that these current policies will condemn Southern Europe to death by slow suffocation, as well as leaving northern Europe, the UK, and the US in a slump for a long time to come.

Policy makers here in the US continue to hint at accounting tricks such as quantitative easing on the premise that central banks swapping one financial asset for another will help incite more speculation. That seems to be doing the trick for the stock market. But this does nothing to boost underlying aggregate demand. How about a solution for Main Street?

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Even as the markets continue to make new post-2008 recovery highs, governments continue to construct policies around bailing out fundamentally insolvent financial institutions. These policies ensure that the bankers and others can continue to get their exorbitant and totally unjustifiable bonuses, thereby sustaining the very practices that created the crisis in the first place. Lloyd Blankfein of Goldman Sachs warned that the bank could shift its operations around the world if regulatory crackdown becomes too tough in certain jurisdictions. To which any politician with an ounce of backbone ought to say, "Good! Take your socially polluting activities elsewhere and leave our populations alone."

Of course, they don't do that. The more likely supine response (as we've already seen in Basel III and Dodd-Frank) is a further undermining of any kind of serious regulation. We tinker around the edges but make no fundamental, structural reforms. It's a national scandal that our most elite businessmen and professionals, who have destroyed the global economy through an unprecedented orgy of mortgage and accounting fraud, have to date gotten away with it scot-free and continue to have a major hand in policy making. Equally incredibly, our governments continue to trumpet the "success" of abominations such as TARP along with their enablers in the media.

As the risk of being called a whiner by Vice President Biden, it has to be pointed out that these very same governments hand out little in spending to underpin the real economy, even as unemployment remains in double digits around the globe. Government support for the real economy via fiscal policy is minimal compared to the trillions thrown at the financial sector. But before we see any kinds of real reductions in unemployment, the cries of "socialism" and "intergenerational theft" rise. The fiscal austerians launch counter-attacks to mobilize against further fiscal expenditures that support employment growth. The expansion of fiscal policy is stopped dead in its tracks.

Curiously, progressives have come to be seen as the enemy because they dare to point out the incoherence and incongruity in current government policy.

For all of the recent hoopla in the stock market recently, much of the latest economic data is consistent with a slow to stagnant economic environment. In the US, inventories are rising. ISM new orders are now just barely hovering above 50, which usually marks the onset of falling levels. The same thing can be said of the leading indicator (which has been falling since the second quarter), and the coincident to lagging indicator ratio. Weekly chains store sales continue to slip toward the April/May lows, while mortgage applications for refinancing are also tipping over, despite the recent drop in mortgage rates. Second quarter revisions of GDP were mild, although this probably marks peak profit margins

Overseas, Japan appears to be reverting back into a recession. Additionally, very few people are looking at the direct impact of China's trade policies and how Beijing's mercantilism is beginning to hollow out other countries' manufacturing bases -- not just in the US but also in other parts of Asia (which are also experiencing decelerations in their exports and purchasing manufacturing indices).

Consumer expectations are tipping over, and we are concerned with a relapse back to a low level of confidence, which never improved from the recession lows. Euro zone company and macro data flow are starting to reflect more fiscal retrenchment , and with the euro higher, exporters may find more competition in the quarters ahead.

Message to today's policy makers: the public debt ratio will fall again when growth resumes. Growth will not resume very strongly unless it is continued to be supported by discretionary fiscal stimulus. There is no magical alternative. Hacking away the last vestiges of fiscal support will simply ensure much more misery, unemployment and social turmoil in the years ahead.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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What Choices Should America Make to Strengthen the Economy?

Oct 5, 2010

Should we listen to deficit hysteria? What should the Federal budget look like? How do we revive our comatose economy? An event today put on by Demos, the Center on Budget and Policy Priorities, The Century Foundation, and the Economic Policy Institute will tackle these questions with speakers including Paul Krugman, Martin Feldstein, Jan Hatzius, Robert Reischauer, and David Walker. Not in DC?

Should we listen to deficit hysteria? What should the Federal budget look like? How do we revive our comatose economy? An event today put on by Demos, the Center on Budget and Policy Priorities, The Century Foundation, and the Economic Policy Institute will tackle these questions with speakers including Paul Krugman, Martin Feldstein, Jan Hatzius, Robert Reischauer, and David Walker. Not in DC? You're in luck -- you can watch livestreaming video from the event here.

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Eliot Spitzer: The Crisis of Accountability

Oct 4, 2010Lynn Parramore

eliot_spitzer-100This is the third installment of "The Influencers," a six-part interview series that Lynn Parramore, the editor of New Deal 2.0 and a media fellow at the Roosevelt Institute, is conducting in partnership with

eliot_spitzer-100This is the third installment of "The Influencers," a six-part interview series that Lynn Parramore, the editor of New Deal 2.0 and a media fellow at the Roosevelt Institute, is conducting in partnership with Salon. She recently caught up with former New York Gov. and ND20 contributor Eliot Spitzer, whose new TV show, "ParkerSpitzer," will launch TONIGHT on CNN, and they talked about the crisis of accountability in American institutions. According to Spitzer, the failures of Wall Street are the symptom of an epidemic that his new show will explore.

Lynn Parramore: As attorney general, you brought a series of high-profile prosecutions to Wall Street. How do you compare their range and results to those following the financial crisis?

Eliot Spitzer: The paramount difference is that we tried to bring prosecutions that led to structural reforms. That was the idea behind the suit against AIG for using deception and fraud to elevate stock price, or the case against Merrill Lynch, where we charged analysts of offering investment advice influenced by gross conflicts of interest. It was important to challenge the whole structure of the banking and financial-services industry and argue for greater accountability. After the economic collapse, what I've seen so far are one-off prosecutions where you catch somebody for insider trading, for example. Given the systemic nature of the problems on Wall Street, the effort should be less on how to address violations in a particular case, but rather the ongoing structural issues.

You've noted that accountability is still a problem on Wall Street. Does the problem extend to other American institutions?

Absolutely. Disaffection of the public has passed from Wall Street to governance and beyond. There is a tremendous sense of failure in accountability in everything from nonprofits to for-profit entities to the whole spectrum of American institutions.

The scholar Viktor Frankl once suggested that the Statue of Liberty should be supplemented by a Statue of Responsibility. Are we striking the right balance between freedom and responsibility?

There is a second half of the equation that we tend sometimes to forget. And when that happens, there's a problem. There's the issue of communitarianism -- we need a sense of community and responsibility to each other that rises in parallel with a sense of the freedom of the individual.

How does accountability impact the legitimacy of our institutions?

This is hugely important. If accountability suffers, then institutions become highly suspect. This happens everywhere from Wall Street to Congress. When people feel no accountability, they are more hesitant to presume that the system is functioning. This affects the entire structure of our democracy.

Do you see anything on the horizon that makes you more optimistic about government's role in regulation that will impact the accountability crisis?

We're at a moment where the regulatory bodies are appreciating what they need to do. Elizabeth Warren, for example, will set a high bar in that regard. On the other side of the equation, you have the public's complete fury at government intervention in any way and the prospect that Republican takeover of Congress will eliminate whatever impetus there may have been.

How do you assess the role journalism has played in demanding accountability?

Journalism cuts both ways. Journalists have certainly shined light on major problems. But you also find examples of journalism that are less noble, that tend to diminish pubic understanding. Journalism really mirrors the rest of society. Its failures and triumphs come in waves.

Is this something you hope to address on your new show on CNN?

We're hoping to put a lot of energy in looking closely at institutions. Whether it is Wall Street or government entities, we want to ask the right questions so we can understand who is doing what. We also want to have guests who can help us understand what is happening to the middle class. And we want to understand the response of the middle class to real frustrations and the ongoing economic crisis. A lot of people say that given what the history is, the response of the Tea Party should not hold -- that they are learning the wrong lessons. The idea is that they shouldn't be blaming government, for example, when many would say that a failure of regulation is what caused the collapse. People wonder, Why haven't we learned the lesson that the enforcement of accountability in the private sector is a positive and critical role that government can play?

What are you most looking forward to in your new role as television host?

I'm looking forward to creating something that hopefully a couple of people will watch that is interesting, fun and informative. I've got a very long reading list to prepare for it -- more intense than anything I've had in my recent stint of teaching!

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Why We Should be Mad as Hell About Florida's Foreclosures

Sep 29, 2010Mike Konczal

mike-konczal-2-100We could be giving underwater homeowners a chance. Instead, we're kicking people out of their homes without due process.

mike-konczal-2-100We could be giving underwater homeowners a chance. Instead, we're kicking people out of their homes without due process.

Given that the IMF and others believe a large part of the "structural unemployment" in our country is related to the struggling housing market and underwater/barely-hanging on homeowners, what is to be done? One choice is to allow for options like lien-stripping in bankruptcy courts, resetting mortgages by zip code, etc. Another option is for courts to accelerate foreclosures by ignoring due process, proper documentation and legal process in order to kick people out of their homes and preserve the value of senior tranches of RMBS while giving mortgage servicers a nice kickback.

What option do you think our country is taking?

We should all be very concerned about the foreclosure situation in Florida. If you are a homeowner or potential homeowner, you should find it offensive that people's property rights are being violated in such a flagrant way. If you are an investor, either as "bond vigilante" or someone with a generic 401(k), you should be worried that servicers have gone rogue and the incentive structure to maximize value instead of fees associated with foreclosures has broken down.

And if you care about basic Western liberalism -- the classical kind, with a Lockean understanding of freedom to own property along with freedoms of speech and religion -- you should be pissed off. This is a clear-cut instance of the rich and powerful decimating other people's property rights, rights that are supposed to protect the weak from the strong, in order to preserve their wealth and autonomy. Unless you think property rights are mere placeholders for whatever the financial sector demands, this should be resisted. This should be viewed as a problem an order of magnitude larger than Kelo v. City of New London.

The short problem is that banks are foreclosing without showing clear ownership of the property. In addition, "foreclosure mills" are processing 100,000s of foreclosures a month without doing any of the actual due diligence or legal legwork required for the state to justify the taking of property and putting people on the street. Even worse, many are faking documentation and committing other fraud in the process. The government is allowing this to happen both by not having courts block it from going forward, but also through purchasing the services of these mills. As Barney Frank noted: "Why is Fannie Mae using lawyers that are accused of regularly engaging in fraud to kick people out of their homes?"

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And the worst part is the lack of conversation about this. Thanks to Yves Smith at naked capitalism for following this story from the get-go; her blog has become the place for anyone interested in this topic (that link is a catch-up post). The rest of the media is starting to catch up to where she was weeks ago.  Here's the Washington Post with the story of an individual caught in one of these nets and ProPublica on GMAC's "robo-signers" who sign off on foreclosures without knowing anything about them.

Also Dean Baker just wrote a good summary of the situation for the Guardian:

As a number of news reports have shown in recent weeks, banks have been carrying through foreclosures at a breakneck pace and freely ignoring the legal niceties required under the law, such as demonstrating clear ownership to the property being foreclosed.

The problem is that when mortgages got sliced and diced into various mortgage-backed securities, it became difficult to follow who actually held the title to the home. Often the bank that was servicing the mortgage did not actually have the title and may not even know where the title is. As a result, if a homeowner stopped paying their mortgage, the servicer may not be able to prove they actually have a claim to the property.

If the servicer followed the law on carrying through foreclosures then it would have to go through a costly and time-consuming process of getting its paperwork in order and ensuring that it actually did have possession of the title before going to a judge and getting a judgment that would allow them to take possession of the property. Instead, banks got in the habit of skirting the proper procedures and filling in forms inaccurately and improperly in order to take possession of properties.

And the situation in Florida is worse than most assume. The specially-created courts see it as their purpose to clear out the foreclosures, as Yves Smith covers here (must read). The most obvious takeaway is that homeowners aren't being given the chance to have their documents properly viewed, have the challenges and proper legal hurdles to putting someone on the street vetted by the courts, and instead are being bribed with an additional month of house time if they don't ask too many questions.

And the biggest fear is that the fraud uncovered at GMAC is the tip of the iceberg for what is going on nationwide.   Keep your eye on this situation.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Visualizing the Nonsense of Fiscal Austerity

Sep 29, 2010

In a new short video, Mark Blyth breaks down the "nonsense" of fiscal austerity, now all the rage in governments across the globe. Austerity, while claiming to be virtuous, really "involves a question of equity: who pays and who doesn't," Blyth explains. "Like a unicorn with a magic bag of salt, it's a nice idea," he says, but in reality it's baloney. Here's why:

In a new short video, Mark Blyth breaks down the "nonsense" of fiscal austerity, now all the rage in governments across the globe. Austerity, while claiming to be virtuous, really "involves a question of equity: who pays and who doesn't," Blyth explains. "Like a unicorn with a magic bag of salt, it's a nice idea," he says, but in reality it's baloney. Here's why:

Before the crisis, everyone took on debt. Those at the bottom 40% of income distribution took it on to pay the bills, because after all they hadn't seen a real wage increase since 1979, Blyth points out. The banks, on the other hand, levered up, which is like "going double or nothing in blackjack," he says. They pushed in all those blackjack chips -- but each was just an IOU, and when the whole thing crashed they became Too Big To Fail.

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So the problem is debt, but not the way fiscal conservatives want you to think. Everyone, from corporate treasurers to single moms, will use any cash they have to pay down debt -- not to spend. So public consumption -- i.e. government spending -- takes the place of private consumption. "All of these pieces are connected," Blyth says. "If the public sector cleans its balance sheet at the same time as the private sector, then the whole economy craters."

"Austerity: the pain after the party," Blyth mimics. "But here's the kicker: the hangover of austerity is not going to be felt the same across income distribution." In fact, a cycle perpetuates wherein those with the lowest income keep bearing the brunt for those with the highest.

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Will It Work and How Will We Know? The Future of FinReg

Sep 28, 2010Mike Konczal

mike-konczal-2-100Mike Konczal and the Roosevelt Institute to discuss the second act of the Dodd-Frank Act.

Next Monday, October 4th, I'll be holding a conference for the Roosevelt Institute titled "Will It Work and How Will We Know? The Future of Financial Reform Conference."

mike-konczal-2-100Mike Konczal and the Roosevelt Institute to discuss the second act of the Dodd-Frank Act.

Next Monday, October 4th, I'll be holding a conference for the Roosevelt Institute titled "Will It Work and How Will We Know? The Future of Financial Reform Conference."

Here at the Roosevelt Institute, we've fought for financial reform over the past year with events including our Make Markets Be Markets project. We've worked to increase the sophistication of the discussion surrounding specific issues. We've also pushed for the role of regulation in creating rules of the road necessary for a healthy financial system that works to build the real economy. The first round of that battle is over with the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act. It's time for phase two.

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Most other policy initiatives have some sort of conceptual metrics associated with them -- "bending the cost curve" for health care, "jobs saved/created" for the stimulus and test scores for No Child Left Behind. Bundled with the goalposts of a metric is an idea of how the policy should work, as the metrics can't really be separated from creating what it is going to measure. So we need to figure out what bending the cost curve of financial reform is: what are ways to know if the policy implementation is going well or poorly? How can we tell if we are closer or further away from a functioning financial market?

We are gathering some of the best minds of financial reform to discuss this. Here is the current schedule, with a panel focus on Too Big To Fail, as well as a focus on the financial markets broadly construed from derivatives to consumer lending.

It's a small venue at capacity, but it will all be online shortly after the conference. We'll be putting out a booklet of white papers by the authors outlining their ideas about what went wrong, how the Dodd-Frank financial reform bill is meant to remedy it and what it would look like to get to a healthy functioning market, which will also be put online. We'll also be running excerpts and opinions by our participants here and at New Deal 2.0 To start, here is Wally Turbeville on derivatives. I hope you check it all out.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Hamptons Institute: Soros, Warren and Greenberger on FinReg

Sep 27, 2010

You may know that over the summer, the Roosevelt Institute partnered with Guild Hall to put on the Hamptons Institute, a gathering of prominent thought leaders in politics, economics, media, and the arts. In case you missed out on the event, full footage of the panels is now online.

You may know that over the summer, the Roosevelt Institute partnered with Guild Hall to put on the Hamptons Institute, a gathering of prominent thought leaders in politics, economics, media, and the arts. In case you missed out on the event, full footage of the panels is now online.

The first panel featured ND20 contributors George Soros, Elizabeth Warren, and Michael Greenberger. Moderator Joe Nocera asked each to reflect on the victories or challenges embodied in the financial reform bill, which had just passed the Senate. In the above video, Soros sums up his feelings: "I think it's good to have it done. But it doesn't really address the problems of the system." Warren, whose work helped create the Consumer Financial Protection Bureau (which she is now helping to get started), echoed the sentiment by saying, "I'm pleased," then adding: "It's not perfect." Both agreed that the most important -- and what Soros deemed "urgent" -- piece of the legislation was the new bureau.

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Michael Greenberger felt the same about the CFPB. But he was perhaps the most optimistic about the entire bill:

While he gave it a "B minus," he added, "I view the B minus as a midterm grade." The battle for meaningful reform continues -- but we now have the tools to fight it.

The event went on to tackle issues such as Europe's economy, building a new Green economy, and investing in the arts and in culture. You can find the rest of the video footage here.

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Report from the Frontlines: Mission Not Accomplished on Derivatives Reform

Sep 27, 2010Wallace Turbeville

stockmarket-1500001FinReg passed. But now the battle rages over how to implement meaningful reform.

stockmarket-1500001FinReg passed. But now the battle rages over how to implement meaningful reform.

It is now obvious that when President Bush made his victory speech on the aircraft carrier in front of the now-famous "Mission Accomplished" banner, he was a bit premature in his assessments.

We should not make the same miscalculation with financial reform. Dozens of fights over these reforms, large and small, continue in Washington, New York and elsewhere. The struggle has moved from the halls of congress to the bureaucracies. At issue is the implementation of 850 pages of legislation concerning financial systems and practices that are difficult for even the most experienced financiers to understand, subjects which are far less appealing to the media. The SEC and the CFTC (Commodity Futures Trading Commission), which are jointly responsible for regulation, understand that their task is enormous and that their resources are stretched.

My interest is primarily in the area of derivatives, and this piece is intended as a "report from the front" in that theatre of conflict. The early stages of the process involve: roundtables hosted by the regulatory agencies; private meetings with industry and public interest groups (in which the attendees and subjects addressed are disclosed, but not the content of the discussions); and comment letters filed with the regulatory agencies. The vast majority of input has come from the financial industry. Proponents of regulation are at an enormous disadvantage. Their resources are meager and their access to information and expertise is minimal compared to the institutions and the businesses that serve them. However, the proponents remain passionate, and they are bolstered by the obvious intent of the legislation.

Several of the issues under discussion get at the core components of the Dodd-Frank Act. One is the transfer of risk-laden derivatives portfolios from the poorly-managed and murky world of bi-lateral contracts into clearinghouses, where the management of risks is monitored and transparent. Another is public availability of trading data, which allows regulators and participants in the marketplace access on equal footing with the dominant trading houses.


The banks and clearinghouses have asserted from day one that not every type of derivative contract can be cleared. Before the passage of Dodd-Frank, much of the discussion of clearing limitations concerned "bespoke" transactions, suggesting one-off, complicated arrangements with multiple terms, unsuitable to the standardized world of clearing. The discussion has shifted to a separate and more troubling issue. The new focus is on standardized contracts that involve risks that are difficult or impossible for clearinghouses to measure. The principle role of clearing is the statistical measurement of predicted price moves and the management of the credit risk associated with those moves. Margin to collateralize the risk is required to offset the risk. If the risk cannot be measured, the adequacy of margin is uncertain, calling into question the integrity of the clearinghouse.

There is tension between Dodd-Frank's intention to move positions into the clearing environment and the need for a secure clearing system. The debate is over how to determine the scope of clearable contracts and use available techniques to maximize the categories of contracts that will be cleared.

Proponents of reform are generally skeptical of the clearinghouses on this issue. Until relatively recently, clearinghouses were owned by the trading firms and operated for their benefit. Clearinghouse profitability is based on volumetric fees, and the banks represent the vast majority of volume. The clearinghouses and banks have freely admitted that financial institutions are both heavily involved and influential in the process of determining the types of contracts that are cleared. Bank involvement is essential, they say, because of their expertise and their ultimate exposure if things go wrong.

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This assertion is deeply ironic and raises some concerns:

• If a transaction's risk cannot be measured adequately to permit prudent collateralization, why should the system allow a financial institution to trade it?

• In the go-go era of derivatives trading, clearinghouses competed to clear products (and increase revenues and share prices) by pushing the envelope of statistical risk metrics. The new emphasis on prudence is startling.

• Clearinghouses are supposed to be experts in measuring derivatives risk. While banks might be a good source of information on a new contract, the clearinghouses must make the decisions. They exist to manage risk, not to further the interests of the clearing members. In reality, this distinction is still blurred for many senior managers of clearinghouses.

• Financial institutions are at risk if a clearinghouse fails; but, recalling the autumn of 2008, so is the public.

Much of the discussion has revolved around share ownership limitation and corporate governance. These are valid concerns. Perhaps a more important focus is the risk committees at clearinghouses. Clearinghouse managers and clearing members (that is to say, the banks) run the core business through these committees. They control the central issues, including the types of contracts that can be cleared. Regulatory or public interest participation in these committees would be an effective way to legitimize the process.

If it is accepted that the risk of certain categories of derivatives cannot be measured adequately to permit conventional clearing, the discussion moves on to techniques that depart from conventional clearing practices to enable more transactions. Three methods, which are not mutually exclusive, have been suggested by proponents:

• Statistical projections used in clearing are based on historic price movements. The idea is to cover some large percentage, often 99%, of historic price moves with margin. There is no reason that margin should be limited to historic movements. If margin collateral exceeded the largest historic movements, more transactions could be cleared.

• Reference prices in problem contracts can often be disaggregated into components: one that is easily cleared and one that is not. This is because of the real-world characteristics of the commodity or financial instrument that is the subject of the contract. Consider a difficult natural gas delivery point that is physically sourced from a readily clearable delivery point. The disaggregated price risk of the clearable point could be cleared, leaving only the stub price differential as a problem contract. Thereby, more risk is cleared.

• The obstacle to clearing problem contracts is unacceptable risk for the clearinghouse. Requiring the clearinghouses to run separate clearing pools in which this risk is limited or eliminated allows the broadest scope of clearing. This is far better than the alternative -- leaving these transactions in the bi-lateral world.

Market Information

A central tenet of Dodd-Frank is that the derivatives trading market should be transparent. All price data should be available to market participants and regulatory authorities. The Act establishes the superstructure, mandating data repositories and (for the most part) "real time" public disclosure.

The quantity of data poses challenges, but these are largely mechanical. The significant issues revolve around the form of data disclosure. The data must be useful to individual market participants in their daily activities if the system is to provide meaningful transparency. The presentation must be uniform and accessible in a way that can integrated into the screen environments used by traders.

The Roundtable discussions concluded unanimously that a data aggregator was essential. This function is not contemplated by Dodd-Frank, but it is required to make the policy work. The discussion also recognized that the aggregator must be independent of influence and that industry ownership and volumetric fee revenue should be avoided. The concepts of a "public utility" and a "common carrier" were used to describe it.

The data assembled by the aggregator will offer a tremendous opportunity for  regulatory authorities to meaningfully monitor the derivatives markets. As an example, consider compliance with the Volcker Rule. It is naïve to believe that there is a bright red line between proprietary trading and banks' other market activities. The aggregator's data base can be analyzed using systems designed to detect activities that might not be in compliance. In addition, the data will represent the comprehensive portfolio of the reporting firms, allowing the regulators to monitor and analyze credit risk and appropriate position limits.

The optimal organizational structure for the aggregator would allow it to service the needs of the regulators, while providing the mandated market transparency in a useful way. This suggests an independent non-profit or limited profit organization, with substantial regulatory involvement, capable of developing analytical systems to benefit the public's interest.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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Guest Post from Yves Smith: Goldman Sachs' Glass Ceiling Remains Intact

Sep 23, 2010Yves Smith

gender-equality-150Without serious structural changes, Wall Street will continue to look like a country club.

gender-equality-150Without serious structural changes, Wall Street will continue to look like a country club.

Three women filed a sex discrimination suit against Goldman seeking class action status. It has gotten some attention in the press and on the Web for not the best reasons, namely, the complaint recounts in some detail how one of the plaintiffs, Christina Chen-Oster, a convertible bonds sales rep, had had a colleague force himself on her after a business-related group outing to a strip club. When she reported it some time after the fact (the perp had asked her to keep it secret), she was increasingly ostracized and marginalized.

While the salacious allegations are a vivid reminder of the sort of indignities that women can experience even in ostensibly well-run firms, they are the most obnoxious and disheartening example of the second-class status that women typically occupy in male-dominated fields. The fact is that Goldman has had long-standing problems with women, and the lawsuit's charges are far more damaging and potentially costly than the commentary indicates.

I joined Goldman in its corporate finance department nearly 30 years ago. Goldman had just been sued for sex discrimination, and the firm seemed eager to counter its reputation as the worst place for women on Wall Street. But it wasn't clear to me that things had changed so much as the worst extremes were addressed. For instance, a highly respected Vice President had propositioned every woman in the department. He was finally hauled before the Management Committee and told to cut it out. I arrived at the firm to learn that there was a betting pool on whether he would revert to his old form with me. While he didn't, a partner in the firm did make advances. When he eventually backed off, the fallback was to give me a checklist of the sort of woman he wanted to date and ask me to set him up with suitable candidates.

Fast forward, and while the firm now has policies on dating, the area where the rubber really hits the road, pay and promotion, appears to be as retrograde as ever. Some of this may result from the shift at Goldman from having a substantial investment banking business to one where traders, the most macho and individualistic players, are now dominant.

Make no mistake: the charges in the suit are serious. It seeks class action status, and gender discrimination suits with similar allegations have won class certification (the process is that the plaintiffs do limited discovery to prove they meet the four criteria for class certification). That means that should the plaintiffs prevail, every woman at the firm in a to-be-determined target time period would be considered in arriving at damages.

The central charge is a classic pay act claim, that women are paid less for doing the same work as the boys. There are multiple mechanisms by which this occurs, in addition to allegations of simply lower compensation for comparable performance. Women are also set up to do less well: the best assignments and territories go to men (the suit gives examples of plum territories and clients being stripped from women and assigned to male colleagues); are asked to do clerical work and training far more than men; and receive less informal mentoring.

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The suit describes how business unit managers have unlimited discretion on pay and promotion of their subordinates. This may not seem unusual, but according to the plaintiffs, a lot of "human capital management" procedures are easily and often gamed. For instance, the firm has "360 degree" reviews, but the boss picks who gets to review a particular subordinate, which can be used to stack the deck, and when he gets back the ratings, he can still rank his troops as he sees fit. Perhaps most important, pay is compounded. If one person is paid 10% less than other people in their unit, their next year pay is set as a percent increase over prior year pay. So a one-year setback, whether justified or not, will lead to widening differentials over time.

There is every reason to believe this suit will be costly to Goldman, yet have perilously little long-term impact. One of the two firms representing the plaintiffs, Lieff Cabraser, is a class action heavyweight. Goldman is likely to be advised to settle the suit quickly. It does not want Lieff Cabraster doing a lot of discovery. Lieff Cabraster will probably go to the class certification stage (that's when the numbers will start to get large) and see if Goldman initiates settlement talks.

Assuming this plays out according to the normal script, all affected women will get checks. Those who remain, even if the firm agrees to modify some of its pay and promotion practices to manager discretion, are unlikely to see much change. Big dealer firms delegate substantial authority to producers; a Wal-Mart, with its highly codified managerial processes, is in a far better position to curb abuses than a firm where managers operate what amount to franchises in a larger corporate umbrella.

There's nevertheless a tendency to see people like the plaintiffs in this suit as sore losers, when the reality is far more complex. Unfortunately, legal remedies can reinforce the idea that minorities and women can’t succeed on their own and need quotas or other measures to assure they are represented in sufficient numbers. By implication, diversity is in conflict with merit-based policies. As transgendered scientist Ben Barres has pointed out, citing research, “When it comes to bias, it seems that the desire to believe in a meritocracy is so powerful that until a person has experienced sufficient career-harming bias themselves, they simply do not believe it exists.” And examples are widespread in other fields. For example, a 1997 Nature paper by Christine Wenneras and Agnes Wold, “Nepotism and Gender Bias in Peer-Review,” determined that women seeking research grants need to be 2.5 times more productive than men to receive the same competence score. In 1999, MIT published the results of a five-year, data-driven study that found that female faculty members in its School of Science experienced pervasive discrimination, which operated through “a pattern of powerful but unrecognized assumptions and attitudes that work systematically against female faculty even in the light of obvious good will.”

It isn't widely recognized outside the human resources field, but performance appraisal systems have been criticized for over 100 years as being unable to live up to their objectives. Thus, the typical defense against the failure to achieve diversity, that the company was in fact hiring and promoting based on achievement, is hollow. These systems not only are subjective (inherent to most ratings) but also often lead to capricious, even unfair results.

The idea that Goldman, and Wall Street generally, which for decades have had their pick of top business and law school graduates, can't find women of the same caliber as men simply doesn't pass the common sense test. But “diversity” has the effect of shifting attention away from the fact that companies may be inbred. Conservatism and a common preference to hire in your own image leads many firms to stick with their tried-and true profile, which in most cases is Caucasian and male. Sadly, the C level and boards at most large companies still look more like country clubs than the US as a whole, and that's still not likely to change soon.

Yves Smith is the founding editor of Naked Capitalism. She is a former employee of Goldman Sachs.

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