Steps that can safeguard America’s economy

By Lawrence Summers

Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers, the Fed has demonstrated a willingness to take on directly the most problematic parts of Bear Stearns’ balance sheet, and the Fed funds rate has been reduced by 200 basis points within 7 weeks.

At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac (the government-sponsored enterprises) to purchase more than an additional $300bn in mortgage-backed securities.

There is substantial scope for further regulatory action as only a third of the punitive capital charge placed on Fannie and Freddie years ago has been lifted. Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.

The confidence engendered by all of this has led to some normalisation in credit markets. Short-term Treasury note yields that had fallen to their lowest levels in a half century have risen to more normal levels as most credit spreads have narrowed considerably and market estimates of future volatility have declined.

It is sometimes darkest before the dawn. For the first time since last August, I believe it is not unreasonable to hope that in the US, at least, the financial crisis will remain in remission. The prices of many assets are discounting a severe recession or worse. Yet the combination of monetary and fiscal stimulus along with growing exports coming from a weaker dollar may limit the downturn, and newly induced demand for mortgages may support the mortgage market.

Just as cascading liquidations have contributed to a vicious cycle of both real and financial contraction, it is possible that recovery can be a virtuous circle in which improved financial and real economic performance are mutually reinforcing.

Wise policymakers hope for the best but plan for the worst. Liquidity provision and government efforts to support the mortgage markets can address problems of confidence. But they cannot ultimately prevent asset prices from declining to true values or make troubled financial institutions solvent.

While spreads have come in somewhat, markets continue to price in significant probabilities of default for even the most apparently strong financial institution, reflecting in part concerns about their solvency. At the same time it needs to be recognised that the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system.

All of this implies that a priority for financial policy has to be increases in the level of capital held by financial institutions. Capital infusions to date fall far short of prospective losses. Without new capital, the financial sector will operate with too much risk and leverage or will put the economy at risk by restricting the flow of credit.

On a favourable economic scenario, increases in capital will accelerate the return to normality in sectors such as municipal finance and student loans where credit has dried up, and will offset the moral hazard created by lending to financial institutions.

On an unfavourable scenario, increased capital will protect the taxpayers who bear the burden of government and Fed guarantees, will make possible more immediate and honest recognition of losses and will reduce the risk of vicious balance sheet contraction if asset values decline again.

The policy approach should start with the GSEs. These institutions’ viability with anything like their current operating model depends on the implicit federal guarantee of their several trillion dollars of liabilities. It is appropriate at a time of crisis in the mortgage markets that they become, as their regulator put it last week, the “lender of first, last and every resort”.

It is not appropriate that their shareholders’ “heads I win, tails you lose” bet with the taxpayer be expanded for this purpose. Given their past and prospective losses, their regulator – supported by the Treasury, the Fed and, if necessary, Congress – should insist that they stop paying dividends and raise capital promptly and substantially as they expand their lending. In the unlikely event that the boards of these institutions refused, policymakers should put them into an appropriate form of administration that insures that their obligations will be met.

Because they do not have a similar public mission and are operated with more financial rigour and closer regulation, the situation is somewhat different with respect to other financial institutions.

As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital. Consideration should be given to collective actions designed to destigmatise cutting dividends or raising equity. The idea of linking access to Fed credit and measures to attract capital should also be explored. At a time when much is being given to financial institution shareholders and management, action to help the economy and protect the taxpayer should be expected in return.

Food crisis is a chance to reform global agriculture

By Martin Wolf

Of the two crises disturbing the world economy – financial disarray and soaring food prices – the latter is the more disturbing. In many developing countries, the poorest quartile of consumers spends close to three-quarters of its income on food. Inevitably, high prices threaten unrest at best and mass starvation at worst.

The recent price spikes apply to almost all significant food and feedstuffs (see charts). Yet these jumps are themselves part of a wider range of commodity price rises. Powerful forces are linking prices of energy, industrial raw materials and foodstuffs. Those forces include rapid economic growth in the emerging world, strains on world energy supplies, the weakness of the US dollar and global inflationary pressures.

Yet the food element of this story carries its own significance. As HSBC points out in a recent analysis*, with rice and wheat prices spiking, riots on the streets of the Philippines, Egypt and Haiti and moves by India, Vietnam, Cambodia and China to restrict rice exports, food is suddenly an even hotter issue than normal.

So why have prices of food risen so strongly? Will these higher prices last? What action should be taken in response?

On the demand side, strong rises in incomes per head in China, India and other emerging countries have raised demand for food, notably meat and the related animal feeds. These shifts in land use reduce the supply of cereals available for human consumption.

Furthermore, rising production of subsidised biofuels, further stimulated by soaring oil prices, boosts demand for maize, rapeseed oil and the other grains and edible oils that are an alternative to food crops. The latest World Economic Outlook from the International Monetary Fund comments that “although biofuels still account for only 1½ per cent of the global liquid fuels supply, they accounted for almost half of the increase in consumption of major food crops in 2006-07, mostly because of corn-based ethanol produced in the US”.

Meanwhile, aggregate production of maize, rice and soyabeans stagnated in 2006 and 2007. This was partly the result of drought. Also important, however, have been higher prices of oil, since modern farming is so energy-intensive. With weak growth of supply and strong increases in demand, cereal stocks have fallen to their lowest levels since the early 1980s. Declining stocks undermine the widely shared belief that speculation has driven the rising prices, since stocks would be rising, not falling, if prices were above market-clearing levels.

Vastly more worrying than speculation is the weak medium-term growth of supply. The rapid increases in yields of the 1970s and 1980s, at the time of the “green revolution”, have slowed. Given the stresses on water supplies, longer-term supply prospects would look poor even if diversion of land for production of biofuels were not adding to the pressure.

Are prices going to remain high? Two opposing forces are at work. The first is the market, which will tend to bring prices back down as supplies expand and demand shrinks. But the latter is also what we want to avoid, at least in the case of the poor, since reducing their consumption is not so much a solution as a failure. The second force is the current intense pressure on the world’s food system. This is true of both demand and costs of supply. Prices are likely to remain relatively elevated, by historical standards, unless (or until) energy prices tumble.

This, then, brings us to the big question: what is to be done? The answers fall into three broad categories: humanitarian; trade and other policy interventions; and longer-term productivity and production.

The important point on the first is that higher food prices have powerful distributional effects: they hurt the poorest the most. This is true both among countries and within them. The Food and Agricultural Organisation in Rome recently listed 37 countries in substantial need of food assistance. Moreover, according to the World Bank, soaring food prices threaten to make at least 100m more people hungry.

Increases in aid to the vulnerable, either as food or as cash, are vital. Equally important, however, is ensuring that the additional supplies reach those in greatest difficulty. The options depend on the sophistication of a country’s bureaucratic machinery. But they include work paid directly with food (which is a good way of screening out the better-off), a rationed supply of cheap food for the poor or cash vouchers. Those most in need will be the landless, both rural and urban, and marginal subsistence farmers.

Now turn to the policy interventions. Protection, subsidies and other such follies distort agriculture more than any other sector. Alas, the opportunity to eliminate protection against imports offered by exceptionally high world prices is not being taken. A host of countries are imposing export taxes instead, thereby fragmenting the world market still more, reducing incentives for increased output and penalising poor net-importing countries. Meanwhile, rich countries are encouraging, or even forcing, their farmers to grow fuel instead of food.

The present crisis is a golden opportunity to eliminate this plethora of damaging interventions. The political focus of the Doha round on lowering high levels of protection is largely irrelevant. The focus should, instead, be on shifting the farm sector towards the market, while cushioning the impact of high prices on the poor.

Finally, far greater resources need to be devoted to expanding long-run supply. Increased spending on research will be essential, especially into farming in dry-land conditions. The move towards genetically modified food in developing countries is as inevitable as that of the high-income countries towards nuclear power. At least as important will be more efficient use of water, via pricing and additional investment. People will oppose some of these policies. But mass starvation is not a tolerable option.

The food and fuel crisis of 2008 is a cry for our attention. Nobody knows how long these shocks will last. But they demand rapid policy changes across the globe. We must choose between fragmenting world markets still further and integrating them, between helping the poor and letting even more starve and between investing in improving supply and allowing food deficiencies to grow. The right choices are evident. The time to make them is now.

Clinton Caught in Time Warp With Windfall Oil Tax: Amity Shlaes

May 2 (Bloomberg) -- Jimmy Carter's in the news again. The former president wants a windfall-profits tax. No wait, he wants the U.S. to recognize Hamas. Hillary Clinton is the one who wants a windfall-profits tax.

It seems that every year, usually just around the time Memorial Day comes into view, a politician demands a tax on oil profits. Richard Nixon's economists offered one up in 1973, arguing, almost vindictively, that they were justified in imposing a stiff levy because the tax would ``make up in some degree for windfalls which have occurred in the past.''

Carter proposed one in 1977, saying his administration ``will ask private companies to sacrifice just as private citizens do.'' A few years ago Senator Charles Schumer of New York put forward a tax in the name of funding a $100-per-family income tax credit.

Senator Clinton has couched her support in terms of the hunt for revenue: ``I'm the only one with a plan,'' she said earlier this week. And lots of other Americans, not just Democrats, are eager for a break at the pump.

What to make of it? Insanity has been defined as doing the same thing over and over again, and each time expecting a different result. By this definition, a new windfall-profits tax would suggest a sort of collective insanity. For, as our country's history with the great Windfall-Profit Tax of 1980 amply demonstrates, there are lots of reasons to oppose it.

Not Much Revenue

The first is that such taxes tend to yield disappointing revenue. Back in 1980, lawmakers were riled over the news of Arab Light hitting $36 a barrel, up from just $14 in 1978.

Congress, the world's worst economic forecaster, began to envision an endless increase in the price of oil and an endless gusher of revenue. Lawmakers imposed a levy of as much as 70 percent based on a per-barrel increase over a designated base price.

Carter wasn't necessarily comfortable with the recent ending of price controls. And he knew that Mobil Oil Corp. and other oil companies were excited about future discoveries.

Now he consoled himself with the thought that this windfall tax would take the profit of such discoveries from such irritating petrocrats.

Of course, oil prices didn't surge -- in fact, they dropped. There was something at work that lawmakers hadn't thought of. The oil-price increases had been partly a monetary event, reflecting the inflation that the new Federal Reserve Chairman, Paul Volcker, was then vanquishing.

Quiet Death

Some would argue that inflation plays the same role in goosing commodity futures prices today. By 1986 oil prices had collapsed. Disappointing windfall tax revenue reflected that.

At the Cato Institute, authors Jerry Taylor and Peter van Doren reckon that the windfall profits tax generated $40 billion or so, instead of the $175 billion once projected. By 1988, embarrassed lawmakers allowed the tax to die a quiet death.

But in the course of its life, the tax did plenty of damage. As a Congressional Budget Office paper from 1983 pointed out, the levy early on proved itself an administrative nightmare since it effectively required the collection of ``detailed information on each individual oil-producing property in the United States.''

What's more, the tax so depressed business activity that it had an effect on the general economy.

Experts Baffled

But in 1980 the economy's refusal to recover was baffling some economists. One of their conclusions, published in the New York Times, was that the windfall-profits tax was being passed along to consumers, reducing disposable income and so demand. In other words, it was doing the opposite of what the tax-rebate checks are supposed to be doing this month and next.

Specifically, the Windfall Tax made investment and production at domestic oil companies more expensive. Mobil was right. You needed incentives to want to drill. That deterrent slowed the sort of research that might have made energy less expensive earlier.

A Congressional Research Service paper suggested that the 1980 law actually increased foreign imports relative to domestic production.

So where we are now is that Clinton and her colleagues are backing a move that would strengthen the position of Middle Eastern OPEC members and Hugo Chavez of Venezuela.

No Free Trade

That's certainly consistent with her perverse refusal to help save Colombia from the arms of Hugo by rejecting the Colombian-American free trade agreement. But it's not exactly a position that leads to U.S. energy independence or suits our country's green ambitions.

Clinton argues that the windfall tax is valuable because it will subsidize a summer gas tax holiday for drivers. Senator John McCain, the presumptive Republican presidential nominee, has also endorsed a gas tax holiday. Such a break will feel good, but like the windfall tax, may prove counterproductive.

As economists such as Harvard's Greg Mankiw have pointed out, if you want domestic innovation, it would make more sense at this point to raise the gas tax and let the companies keep the rest of their resources. Then they would work on green technology. And of course, do the most important thing of all: drill.

All these missteps by his opponents actually leave Senator Barack Obama looking pretty good. He commented recently on the gas tax holiday, saying ``this isn't an idea designed to get you through the summer. It's designed to get you through the election.''

He's right. In her energy plans, Clinton believes she's found a political windfall. But those plans are so poorly crafted they may prove to be what wipes her out.

Fed `Rogue Operation' Spurs Further Bailout Calls (Update1)

May 2 (Bloomberg) -- A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is ``a potential crisis in the student-loan market'' requiring ``similar bold action,'' Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

Student loans are just the start. Former Fed officials and other Fed-watchers say that Bernanke's actions in saving Bear Stearns will expose the central bank to continuing pressure to use its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians. The Fed satisfied Dodd's request today, expanding the swaps to include securities backed by student debt.

``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Critics argue that the result will be to foster greater risk-taking among investors emboldened by the belief that the government will bail them out of bad decisions.

The Fed's loans to Bear Stearns were ``a rogue operation,'' said Anna Schwartz, who co-wrote ``A Monetary History of the United States'' with the late Nobel laureate Milton Friedman.

`No Business'

``To me, it is an open and shut case,'' she said in an interview from her office in New York. ``The Fed had no business intervening there.''

There are already indications that investors perceive the safety net to be widening as a result of the actions by Bernanke, 54, and New York Fed President Timothy Geithner. The Bear Stearns bailout and an emergency facility to loan directly to government bond dealers triggered a decline in measures of credit risk for investment banks and for Fannie Mae, the Washington-based, government-chartered company that is the nation's largest source of funds for home mortgages.

Yield differences between Fannie Mae's five-year debt and five-year U.S. Treasuries have fallen to 0.55 percentage point, from 1.15 percentage points on March 14, the day the Fed's Board of Governors invoked an emergency rule to lend $13 billion to Bear Stearns.

``The market understood that this is the method by which Fannie Mae and Freddie Mac could be bailed out if necessary,'' Poole said.

Wall Street Impact

The cost of default protection on Merrill Lynch & Co. debt fell to 1.4 percentage point by April 30 from 3.3 percentage points on March 14, CMA Datavision's credit-default swaps prices show. The cost of protection on Lehman Brothers Holdings Inc. securities has fallen to 1.5 percentage points from 4.5 percentage points over the same period.

Fed Board spokeswoman Michelle Smith declined to comment, as did New York Fed spokesman Calvin Mitchell.

On March 16, two days after the Fed provided its Bear loan, it agreed to finance $30 billion of the firm's illiquid assets to secure its takeover by JPMorgan Chase & Co.

The Standard & Poor's 500 Financials Index had lost 12 percent in the three weeks prior to March 14; Geithner defended the loans before the Senate Banking Committee on April 3, saying that the Fed needed to offset risks posed to the entire financial system.

`Everyday Life'

A systemic collapse on Wall Street would also mean ``higher borrowing costs for housing, education, and the expenses of everyday life,'' Geithner, 46, said.

While the Fed must by law withdraw its financing backstop for investment banks once the credit crisis passes, investors will probably still bet on its readiness to intervene.

``There is no way to put the genie back in the bottle,'' Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. ``What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.''

Stern noted that he supported the Fed's moves to restore financial stability.

Fed Board officials haven't explained in detail how they plan to curtail moral hazard, the danger of encouraging investors to take on more risk out of confidence in a rescue.

Heat of Battle

``It is very hard in the middle of a crisis to know where to draw lines,'' said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. ``They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.''

Lawmakers plan to debate the management of risk and role of supervisors in coming weeks and months. House Financial Services Committee Chairman Barney Frank said April 23 that new rules are needed to deal with a lack of regulation of risk.

Geithner told Congress April 3 that the direct lending needs to be complemented with ``a stronger set of incentives and requirements for the management of liquidity risk.''

The risk to the Fed is that it is routinely asked to step in and support insolvent companies whose creditors are on the run, economists say.

``Discount-window accommodation to insolvent institutions, whether banks or nonbanks, misallocates resources,'' Schwartz said in a 1992 lecture available on the St. Louis Fed Web site. ``Institutions that have failed the market test of viability should not be supported by the Fed's money issues.''

`Moral-Hazard Problem'

Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. ``The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,'' they wrote. That ``creates a potentially severe moral-hazard problem.''

Whatever regulations and incentives the Fed tries to put in place now would be evaded by the market's innovation of new types of products, Goodfriend said in an interview. Investors would nonetheless still count on the safety net, he added.

``We have to start now to recognize the strategic instability of the path we are on,'' said Goodfriend, now a professor at Carnegie Mellon University's Tepper School of Business in Pittsburgh. The Fed needs to prepare markets for how it won't intervene, which it didn't do before the Bear Stearns meltdown, he said.

Lending Treasuries

The Fed also influenced market incentives when it introduced the so-called Term Securities Lending Facility. The program is designed to lend up to $200 billion of Treasury securities from the Fed's holdings to Wall Street bond dealers in return for commercial and residential mortgage bonds among other collateral. Congress has noticed the program favors mortgage credits, and Dodd asked the Fed to swap some of its $548 billion in Treasury holdings for bonds backed by student loans.

While Bernanke rebuffed Kanjorksi's request for direct loans in a March 31 letter, Fed officials today expanded the collateral they accept under the TSLF. The facility now includes all AAA rated asset-backed investments, including bonds backed by student loans. Former Fed officials say it is risky for the central bank to use its portfolio to address specific markets and satisfy Congress without saying where it will stop.

``If there is a public purpose in lending to investment banks, and taking dodgy mortgage securities as collateral, then it is a question of degree about other potential lending,'' Vincent Reinhart, former director of the Fed board's Division of Monetary Affairs, said in an interview. ``That's the consequence of crossing a line that had been well established for three- quarters of a century.''