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Economics focus (Nearly) nothing to fear but fear itself
In a guest article, Olivier Blanchard says that policymakers should focus on reducing uncertainty
RISES feed uncertainty. And uncertainty affects
behaviour, which feeds the crisis. Were a magic
C
wand to remove uncertainty, the next few quarters
same goes for firms: given the uncertainty, why
build a new plant or introduce a new pro duct now?
Better to pause until the smoke clears. This is perfectly understandable behaviour on the part of
would still be tough (some of the damage cannot be
undone), but the crisis would largely go away.
consumers and firms—but behaviour which has led
to a collapse of demand, a collapse of output and
From the Vix index of stockmarket volatility (see
chart), to the dispersion of growth forecasts, even to
the deep recession we are now in.
So what are policymakers to do? First and forethe frequency of the word "uncertain" in the press,
most, reduce uncertainty. Do so by removing tail
all the indicators of uncertainty are at or near all-time
risks, and the perception of tail risks. On the portfohighs. What is at work is not only objective, but also
lio side, establish a price, or at least a floor on the
subjective uncertainty, or what economists, following Chicago economist Frank Knight's early loth-cen- Olivier Blanchard is the price, of the troubled assets. Ring-fence them or
take them off bank balance-sheets. On the contury work, call "Knightian uncertainty". Objective IMF's chief economist
sumption side, commit to do whatever it will take
uncertainty is about what Donald Rumsfeld (in a different context) referred to as the "known unknowns". Subjective to avoid a Depression, from fiscal stimulus to quantitative easing.
uncertainty is about the "unknown unknowns". When, as today, Commit to do more in the future if necessary. Above all, adopt
the unknown unknowns dominate, and the economic environ- clear policies and act decisively. Do too much rather than too litment is so complex as to appear nearly incomprehensible, the re- tle. Delays in financial packages have cost a lot already. Further
sult is extreme prudence, if not outright paralysis, on the part of rounds of debate will stoke uncertainty and make things worse.
Second, undo the effects of uncertainty on the portfolio side,
investors, consumers and firms. And this behaviour, in turn,
feeds the crisis.
and help recycle the funds towards risky assets. The standard adIt affects portfolio decisions. It has led to a dramatic shift away vice here is to return the private financial sector to health through
from risky assets to riskless assets, or at least assets perceived as recapitalisation. That is absolutely right, but easier said than
riskless. It sometimes looks as if investors around the world only done. And, while damage is slowly repaired, it makes sense for
want to hold American Treasury bills. Why? At the start was the states to recycle part of the funds themselves. To caricature: if the
realisation that many of the new complex assets were in fact world loves American Treasury bills but the funds would be
much riskier than they had seemed. This realisation has now more useful elsewhere, then the government should issue the
morphed into a general worry about nearly all risky assets, and bills, and use the proceeds to channel the funds where they are
about the balance-sheets of the institutions that hold them. "Bet- needed. It should buy some of the riskier assets, and return some
ter safe than sorry" is the motto. Unfortunately, while the motto of these funds back to emerging-market countries to offset capital
may make sense for individual investors, it is having catastrophic outflows. This is indeed close to what America's Federal Reserve
macroeconomic consequences for the world. It is triggering enor- is now doing with quantitative easing at home and swap lines to
mous spreads on risky assets, a credit crunch in advanced econo- foreign central banks. The only difference is that the Fed issues
money rather than treasury bills in exchange for its purchases. It
mies, and major capital outflows from emerging countries.
It affects consumption and investment decisions, and is large- would make more sense for the Treasury to be involved, and to
ly behind the dramatic collapse in demand we have observed separate more clearly the role of fiscal and monetary policy, but,
over the last three months. Sure, consumers have lost a good part in the current state of play, this is a minor wrinkle. Either will do.
of their wealth, and this is reason enough for them to retrench.
But there is more at work. If you think that another Depression Retail therapy
might be around the corner, better to be careful and save more. Third, undo the effects of the wait-and-see attitudes of consumBetter to wait and see how things turn out. Buying a new house, a ers and firms on the demand side. Get them to spend more, and
new car or a new laptop can surely be delayed a few months. The have the state do some of the spending itself Offer incentives to
buy now rather than later; for example, temporary subsidies to
consumers who turn in a clunker and buy a new car, a measure
adopted in France. Increase spending on public infrastructure, a
central component of President Barack Obama's programme.
Both types of measures are indeed present in the fiscal pro-
► Obama has them in its sights. In testimony
released on January 23rd, Timothy
Geithner, now America's treasury secretary, said there needed to be more transparency and accountability. In the short term,
he suggested imposing centralised clearing—something associated with exchanges—on parts of the market that can
be standardised. Days earlier, the Group of
Thirty, a panel of world financial experts,
spoke of big shortcomings in the infrastructure supporting OTC derivatives.
Already, though, the distinction between arc and exchange trading is blurring. As OTC volumes have slumped, efforts to make the markets more
"exchange-like" have increased. Many interest-rate swaps and credit-default swaps,
now traded OTC, can be standardised. Inertia and brokers' vested interest in protecting their high-margin franchises have
kept them off-exchange.
Meanwhile, the exchanges are making
forays into the OTC area. In January a subsidiary of NASDAQ, an American stock exchange, launched a central clearing house
for interest-rate swaps. Its London equivalent, LIFFE, has been granted regulatory
approval to offer clearing of credit-default
swaps, which provide insurance against
default and are especially closely watched
by regulators because of the surge of bad
debts. Bucking a trend in the finance industry, clearing houses are still hiring staff,
such as IT specialists and risk managers.
The exchanges say that by offering the
flexibility of OTC markets with central
clearing and automated processing, they
provide the best of both worlds: customisation (within limits) coupled with reduced counterparty and operational risk.
Counterparty risk is reduced since all parties work through the same clearing mechanism That leaves less chance of gridlock
when a big institution fails. Operational
risks are fewer, because exchanges have
been early adopters of automated processing systems, whereas OTC systems are often outdated and time-consuming. Exchanges, finally, produce a plethora of
information about prices and markets, a
valuable public good.
This could mark a reversal of fortune
for the OTC market, where trading volumes had grown to almost $700 trillion at
1,1148**
A.
181" 83
last count, a ninefold increase in a decade.
Yet OTC products have their own blessings; they allow bankers to tailor financial
products to their customers' needs. Their
relationship with exchanges need not be
wholly adversarial. Financial innovations
may start out in OTC markets and move to
exchanges as they mature. Youth may
sometimes be wild, but it should be nurtured, not suppressed. ■
America's mortgage agencies
Government-sponsored anxiety
NEW YORK
A source of support for banks when markets first crumbled is causing concern
THEY no longer hog the headlines, but
1 America's government-sponsored
mortgage agencies, Fannie Mae and Freddie Mac, continue to rack up huge losses.
As they wrestle under government "conservatorship", fears are also growing over
the health of their corporate cousins, then
Federal Home Loan Banks (FHLBS), which
have so far survived the credit crunch.
Fannie and Freddie, in the red for five
consecutive quarters, have said in filings
that they could need $5.1. billion of government aid, on top of $14 billion already
handed to Freddie. Freddie is in particular
trouble, with negative shareholders' equity of $14 billion on September 3oth.
This is worse than imagined. The duo
could suck up at least $1.2o billion of public cut them any slack. They do not have to abmoney this year, estimates Rajiv Setia of sorb all the market losses because the secuBarclays Capital. At this rate, they will vie rities are classed as "held to maturity". But
with American International Group to be- if these impairments are deemed "other
come America's biggest money-pit.
than temporary", their capital levels could
Unlike Fannie and Freddie, the FHLBS be hit hard. The banks argue that they have
played a subdued role in the good times. no intention of selling the securities. But
When markets dried up, however, they Mr Lockhart says he has been pushing for
lent heavily. Advances to their more than "a more rigorous process" in determining
8,000 member banks rose by almost 60%, the depth of the wounds.
to roughly $1. trillion (see chart). The list of
Mr Lockhart insists that the FHLBS are
the biggest recipients is like a who's who of collectively solvent, and analysts agree.
the sickly, including Citigroup, Country- Their losses on mortgage securities are unwide and Washington Mutual.
likely to exceed 3.0% of their combined capThis business has held up well so far. ital of $57 billion, reckons Mr Setia, which
But, although no borrower has defaulted would be painful but manageable. And if
on FHLB debt, the risk of this grows as borrowers start to fail en masse, the homemore banks fail. A more immediate worry loan banks will at least be first in line for re-