Quick Recap: Eric Rosengren

"The Federal Reserve must respond as vigorously to inflation that is too low as we have, historically, when inflation has been too high."
"Policymakers should remain patient about removing accommodation until it is clear that we are on the path to achieving [our] 2% inflation target..."- Eric Rosengren 

President and CEO of the Federal Reserve Bank of Boston Eric Rosengren gave a rather short presentation tonight on the implications of low inflation. His main point: the Fed needs to respond to inflation that is too low as forcefully as it would to inflation that is too high. Rosengren's main concern is the current US inflation rate, which stands below the Fed's 2% target. With interest rates remaining near zero after QE, another obstacle for the Fed is deciding when to start raising rates to a more normal level.  Rosengren suggests that the Fed should be patient in the process of raising interest rates until inflation reaches a level closer, or at 2%. Why is it so hard to raise inflation rates right now? According to Rosengren, major factors are the general fall in commodity prices, including oil and agriculture and the appreciating dollar. Rosengren used Japan and Europe as examples of the risks of letting inflation rates slip, leading to deflationary responses in the economy. This contributes to another concern: the Fed's loss of creditability from its inability to reach its target rate, ultimately lowering consumer and producer expectations.  After using graphical evidence to present the association between high unemployment/ lower inflation (low unemployment/ higher inflation), Rosengren expressed his goal of reaching an even lower unemployment rate of 5.25% (in comparison to the current 5.8%).

Rosengren's talk was more informative than provocative. The talk was very relevant to class material and I enjoyed hearing his summary and "safe" opinions on issues in current monetary policy.  If you missed it, revisit The Economist article we read a few weeks ago - it overlaps with many of Rosengren's points about the dangers low inflation.

Reflection on Michael Lewis's The Big Short: Inside the Doomsday Machine

(Note: Relevant article at the end)

If you’re looking for a textbook, definitional account of the Financial Crisis, this is not the book for you. Rather, Michael Lewis describes the onset of the housing bubble and eventual crash using a dry-humored, story-like style. His book is both entertaining and informative, especially for those (like me) who lack extensive background in the development of the housing bubble. By telling the stories of a few men who recognized the failure of the subprime mortgage bond market before it happened, Lewis explains how subprime lending worked and why the market essentially failed.

The Wall Street “big shots” like Goldman Sachs, Merrill Lynch, Bear Sterns, Morgan Stanley, and JP Morgan found themselves in the midst of a booming mortgage bond market that took off in the 1980s. Mortgage bonds, as Lewis describes, were “a claim on the cash flows from a pool of thousands of individual home mortgages” (7). Investment banks structured mortgage bonds by “tranches.” The lowest tranches were more risky, with higher interest rates, while higher tranches had lower interest rates and lower risk. Subprime lending began as lenders disregarded the fact that a low credit scored- borrower may not be able to make mortgage payments, because as home prices kept rising, borrowers could just pay off the mortgage by selling the house. As subprime mortgages became packaged into bonds, investors relied on Moody’s and Standard & Poor’s ratings to make their investment decisions, where riskier mortgage bonds would receive lower ratings. Lewis, however, highlights a botch in the rating system, found in collateralized debt obligations (CDOs). AIG insured CDOs, which “disguise the risk of subprime mortgage loans,” by packaging them with “better loans,” ultimately allowing them to receive a better rating (72). Stephen Eisman, Michael Burry, Jamie Mai and Charlie Ledley not only recognized this “ponzi scheme,” but they took advantage of it.

Lewis introduces Michael Burry, a neurosurgeon with Asperger’s who was fascinated by the bond market, specifically the subprime mortgage boom. Burry watched the housing bubble grow, leading to his discovery and purchase of credit default swaps (CDS)- “insurance against the failure of a mortgage bond” (72).  Eisman, a fickle and hotheaded hedge fund owner, saw disaster coming when Wall Street banks’ fixed-income departments would package mortgage loans with “teaser” fixed interest rates into mortgage bonds. He saw the rating inefficiencies and the potential for profits by betting against (“shorting”) the bonds with the worst underlying loans.  Ledley and Mai started Cornwall Capital Management and executed investments based on predicted failures in certain markets. After getting placed on Deustche Bank’s “institutional” trading platform, they bet against (bought CDS) CDOs. By 2007, as defaults rose and CDOs began to fail in large numbers, Burry and Cornwall Capital sold their credit default swaps and heavily profited. The subprime mortgage- backed financial system collapsed as housing prices fell and borrowers defaulted on their loans, bringing a series of bankruptcies and acquisitions on Wall Street. Lewis ends with the startling statistics, including the Fed’s announcement of a $85 billion towards AIG to pay off its losses on the CDS sold to Wall Street.

I’ll start with what I liked. I liked that Lewis used his book to describe the Financial Crisis from a rare point of view; “rare” based on the fact that he followed those few who predicted and benefited from this economic catastrophe. Instead of saying “This is how the housing bubble started, this is why it was bad,” Lewis takes a journalistic approach (appropriate since he is a financial journalist) and includes quotes and thoughts that these financial geniuses had as they watched the housing bubble expand and pop. For example, Lewis quotes Ledley in his discovery of the botched rating system, “The more we looked at what a CDO was, the more we were like, Holy shit, that’s just fucking crazy. That’s fraud (129). By including actual quotes and reactions of the “winners” in his book, Lewis depicts their personalities and their ability to analyze a complex situation.  Including the fascinating stories behind his core characters, like Murry’s battle with Asperger’s, made learning about the subprime mortgage crisis more personal, enjoyable and overall, readable. The insertion of the “F Bomb” throughout the book made it feel like I was hearing a real conversation between Wall Street honchos and big-time money managers.

While the writing style and context of the book encouraged me to read more Michael Lewis books (next on my list is Panic!), I’m somewhat uncomfortable with his portrayal of these figures as “heroes.” Eisman, Murry and the Cornwall brothers saw an opportunity and seized it. When I was little, I had 10 pennies and gave my younger brother a proposition: “I will trade you ALL of these pennies for that ONE, single dollar bill.” Naively, he thought he struck gold. Does the recognition of an opportunity for personal gain (and his loss) make me a hero? Yes, the housing crisis is far more complex, dealing with numerous additional variables. The point is, the characters in this book also recognized opportunity and seized it. Regardless of their gain, thousands suffered from substantial losses (on the lending and borrowing side). They benefited while everyone else suffered. This, in my opinion, may make Eisman, Murry, Ledley and Mai clever, observant and financially talented—not  heroic.

Lewis acknowledges the weaknesses in rating agencies, but for me, not enough. He constantly points back to Wall Street and the big banks, the investors and manipulation in bond structuring. According to Lewis, Wall Street firms were able “to hide the risk by complicating it.” He includes an interaction between Eisman’s partner and a woman from Moody’s: “How could you rate any portion of a bond made up exclusively of subprime mortgages triple-A?” asked Eisman’s partner. The Moody’s rep responded, “That’s a very good question” (103). Lewis used this to point out that the banks convoluted the structure of subprime mortgage bonds to facilitate more investment. However, reading this made me attribute a large part of the blame to the rating agencies themselves. They have the responsibility of evaluating and reviewing bonds in order to designate a specific rating, meaning they should have reviewed all loans within the bonds thoroughly. So, while I agree that the banks were manipulative in their structuring of the CDOs, Moody’s and S&P are also a large part of the issue.

Reading The Big Short: Inside the Doomsday Machine was both critical in my understanding of the development of the housing crisis and towards my ability to develop an opinion of those directly involved. Prior to this book, I have not considered the position of the rating agencies, who I now think play a substantial role in the mismanagement and mistakes behind CDOs and faults within the subprime mortgage market. Lewis took a darker view of Wall Street, opening his book with discouraging words about working in finance and banking. While I acknowledge that he is far more experienced than I am, I cannot completely agree with the representation of his characters as “heroic” based on the fact that they foresaw the explosion of the housing bubble and used this to reap profits. As far as designating a victim, I still go back and forth between investors and borrowers. Lewis presents his characters as sympathetic to the borrowers. Personally, I can’t help but to feel that both the investors and the borrowers acted without thinking in the long term. 

Recent and relevant article about AIG: Former CEO Hank Greenberg files a lawsuit against the US Government for 'overstepping its authority in demanding a 79.9% equity stake in exchange for providing an $85 billion emergency loan." ....Mr. Greenberg, you accepted the bailout package and you needed it. There's no such thing as a free lunch. 

http://online.wsj.com/articles/greenberg-may-be-called-to-testify-at-aig-trial-1414970835 

Question from Tuesday

HOW does an economy become internationally illiquid?

Brazil in the News

http://online.wsj.com/articles/brazils-currency-shares-slump-on-rousseff-re-election-1414413609

After discussing and reading about financial panics and the economic consequences of loss of confidence, I thought I'd blog about Brazil's buzz in the news. President Dilma Rousseff's re-election has created pessimistic reactions, socially and economically (this article covers reactions over social media, especially Facebook, possibly contributing to Facebook's increased stock price: http://online.wsj.com/articles/after-vote-brazilians-lash-out-on-social-media-1414443541). 

Economically, investors are reluctant and skeptical about Rousseff's capabilities and plans to pull Brazil out of its slump. This lack of confidence and skepticism is reflected in the devaluation of its currency and its expectation for slow growth (less that 0.5% according to this article). Although Rousseff promises reform, investors are still not quite confident that she can sustain these promises.  Going off of Chang's piece, it seems that investors are showing broader feelings of "bad policy." It seems that they are holding expectations of poor policy initiatives carried over from Rousseff's previous term. According to the article, the only way to "calm" these concerns and further calm the markets is to "quickly name a new economic team, including a finance minister who can reassure investors that the country’s fiscal situation is under control." The problem: empty promises. What are the global implications? Well, if there is loss of confidence internally, especially with quantitative evidence like currency and poor growth statistics, then external confidence probably won't be strong either, discouraging foreign investment. Maybe this devaluation can encourage some export promotion, but for now it looks like the government needs to get moving on these promises, before every Facebook status sh*ts on them.  

China is still planned, but what's next?

Looking back at our discussion from Day 3, we summarized that Wolf and Stiglitz have two different perceptions on the reasons behind China's success. Wolf, with his push for unfettered, liberal globalization, argues that China's economic growth has stemmed from its movement towards more liberal policies, ultimately fostering more growth. Stiglitz, who advocates for a more highly regulated globalization process, would agree that China has opened its economy, but it has done so slowly, and is still classified as a highly planned economy. Alon et. al's piece reminded me of this distinction between previous authors. This Economic Letter acknowledges China's increased foreign investment with the goal of accessing resources (natural), technology and capital inputs. China's growth, along with this pattern, according these authors, suggests that the country will continue to expand in hopes of continuing their growth spurt. This piece also mentions, on several occasions, the state's involvement in investments. On the one hand, between the 1960-2008, China accumulated financial wealth and relaxed restrictions on outflow. Alon et. al writes, "Nevertheless, despite Chinese reforms over the last decade that removed bans on foreign direct investment by the country’s private sector, most outward direct investment during this period was conducted by state-owned or quasi-state-owned firms." Ending here, one could argue that it backs Stiglitz's argument: that although China has liberalized in some aspects, the economy is still largely state-owned, contributing to its expansion. Reading on, the article names 2 motivations that Chinese banks have for seeking a broader international role, both of which deal with the banks looking for ways to develop and escape strict controls ("China’s strict controls on international capital flows and foreign exchange transactions have prompted Chinese banks to look for ways to get around these restrictions"). So, the question remains: what has had a larger impact on China's economic growth? Further, will the state continue to control outward investment, or will Chinese banks push for a more liberalized process?

Milner's Power of Values & the Asian Values Argument

Milner's piece "IPE: Beyond Hegemonic Stability" examines a number of explanatory factors and propositions behind states' actions within the International Political Economy. His section on "the power of values" offers the idea that the social construction of states' identities constrains the choices the states make and pushes them towards certain behaviors. This concept relates to one argument that I have visited in a few of my politics papers- the "Asian Values" argument. According to this argument, Asian values promote “consensus, harmony, unity and community [as] the essence of Asian culture and identity” which conflict with general Western values like “absence of consensus, conflict, disunity, and individualism” (Hoon). The argument supports Milner's point that typical asian values are often integrated into governmental decisions and rhetoric. The conflict between Western and Asian values causes anti-western sentiments within the region and are also a basis for political and regional connections between Asian countries. Milner's Japan/Pacifism example is somewhat similar to the asian values argument, as both could be motivations for less integration into the international economy.  However, this notion of nonmaterial influences may not be as significant, or can even stem from Milner's third point, the influence of domestic politics on the IPE.