Echoes of 1933: the Cyprus Heist by David Beckworth

The Cypriot Haircut by Krugman

You can sort of see why they’re doing this: Cyprus is a money haven, especially for the assets of Russian beeznessmen; this means that it has a hugely oversized banking sector (think Iceland) and that a haircut-free bailout would be seen as a bailout, not just of Cyprus, but of Russians of, let’s say, uncertain probity and moral character. (I think it’s interesting thatMohamed El-Erian manages to write about this thing, fairly reasonably, without so much as mentioning the Russian thing.) 

The big problem, however, is that it’s not just large foreign deposits that are taking a haircut; the haircut on small domestic deposits is a bit smaller, but still substantial. It’s as if the Europeans are holding up a neon sign, written in Greek and Italian, saying “time to stage a run on your banks!”

Why some people are concerned. What is Krugman implying about El-Erian?

Bubbles, Gorton, Krugman and Cyprius-Iceland-Ireland.

The Яussians Are Coming! The Яussians Are Coming! by Krugman

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As long as you haven’t bought into the Barney-Frank-did-it school of thought, you realize that the global crisis of 2008 was in a fundamental sense made possible by the erosion of effective bank regulation. As Gary Gorton (pdf) has documented, we had a 70-year “quiet period” after the Great Depression in which advanced countries had very few major financial flare-ups; Gorton argues, and most of us agree, that the key to this quietness was a constrained, regulated financial system that also limited the opportunities for excessive non-bank leverage. 

But this regulation in turn depended, to an important extent, on limited international capital flows; otherwise regulations made in Washington or elsewhere would have been bypassed via havens like, well, Cyprus. And once capital controls began to be lifted in the 1970s we entered an era of ever-bigger financial crises, starting in Latin America, then moving to Asia, and finally striking the whole world. 

So what are we going to do about this? Cyprus, as a euro-zone country, should really be part of a euro-wide safety net buttressed by appropriate regulation; it’s insane to imagine that the euro can be run indefinitely with merely national deposit insurance. But euro-area deposit insurance doesn’t seem to be in the cards — and anyway, there are plenty of other potential Cypruses out there. 

All of which raises the question, is the era of free capital movement just a bubble, fated to end one of these years, maybe soon?

bubble, bust, rinse, repeat.

Capital Controls Washing Out the Shampoo Economy by Jared Bernstein

OTE readers know I worry about the advent of the “shampoo economy:” bubble, bust, repeat. 

The last few business cycles both here and in other advanced economies have been characterized by this pattern. To be clear, economies are cyclical…that’s a given. But nowhere is it written—well, outside of Minsky—that the cycles have to be driven by debt driven asset (or investment, as in dot.com) bubbles that are particularly damaging when they inevitably burst. (And Minsky didn’t believe financial busts were inevitable. He believed the bubbles naturally grew out of diminished risk adversity as the business cycle heats up, but could be adequately regulated.)

The IMF and Capital Controls by Krugman

Krugman links to:

Capital Control Freaks by Krugman (Slate, 1999)

Don't Blame the Krona by Krugman

One thing that was clear during yesterday’s Iceland conference was that many people here (I’m still in Reykjavik) believe that the floating krona was responsible for the huge capital inflows that set the stage of the crisis. The story they tell is that expectations of a rising krona, combined with relatively high interest rates, drew hot money in via the carry trade. And this story is used to argue that things would have been much better if Iceland had adopted the euro.

I was kind of surprised by this, well, insularity (which I guess is more excusable if you are in fact on an island in the middle of the North Atlantic). For Iceland was by no means unique in its inflow of funds. Here’s the average current account deficit (which is equal to capital inflows) as a percentage of GDP for a bunch of European countries, over the boom years from 2000-2007:

The fact is that there was a tsunami of money flowing from the European core to peripheral economies; Iceland was just part of a broader class that included countries on fixed rates against the euro and some countries already on the euro.

There are valid arguments for euro entry (and arguments against, which I think win on balance). But this isn’t one of them.

Wikipedia - Current Account:

In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). You may refer to the list of countries by current account balance.

The current account balance is one of two major measures of the nature of a country's foreign trade (the other being the net capital outflow). A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse. Both government and private payments are included in the calculation. It is called the current account because goods and services are generally consumed in the current period.^[1]

The balance of trade is the difference between a nation's exports of goods and services and its imports of goods and services, if all financial transfers, investments and other components are ignored. A Nation is said to have a trade deficit if it is importing more than it exports.

Positive net sales abroad generally contributes to a current account surplus; negative net sales abroad generally contributes to a current account deficit. Because exports generate positive net sales, and because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. This however is not always the case with secluded economies such as that of Australia featuring an income deficit larger than its trade deficit.^[2]

Sudden Stops

Highlights of recent NBER forum on research on the global financial crisis

RT @davidwessel, via DeLong Twitterstorm

The last panel looks interesting:

Reducing Country Vulnerability: Capital Controls, Reserves, the IMF, or Something New?

Jeffrey Frankel introduced the final panel. Over the past few decades, countries have relied more heavily on large emergency lending packages to stabilize economies during crises. As the size of the packages increases and contagion has become more virulent, this approach is becoming increasing costly. This panel explored options to reduce country vulnerability. Dominguez, Hashimoto, and Ito show that having measured reserves after appropriately adjusting for exchange rate movements and emergency assistance packages, they served as an important counter-cyclical policy tool for a number of emerging markets during the crisis. Chamon, Ghosh, Ostry, and Qureshi find that certain types of prudential regulations and capital controls can help to strengthen a country's liability structures and to restrain overall credit booms. They show that this helped to stabilize output declines during the crisis. Barkbu, Eichengreen and Mody argue that more innovative approaches need to be considered and they focused in particular on "sovereign cocos": contingent debt securities that automatically reduce payment obligations in the event of debt-sustainability problems.

Zanny Minton-Beddoes chaired the final discussion in which Erdem Basci stressed the importance of exchange rate flexibility, moving towards the greater use of equity-like contracts to share risks, and reducing currency exposure, to stabilize countries during a crisis. He also discussed the measures undertaken by Turkey to manage capital flows, highlighting the innovative use of volatile interest rates, and argued that because of its successful policy management, Turkey did not need to use capital controls. Olivier Blanchard reminded us of the challenges of large capital inflows-from bubbles and overheating to "sudden stops". He suggested that value of more borrowing in domestic currency and macro-prudential measures in response to these inflows-which would include a continuum of measures ranging from domestic macro-prudential measures to broad capital controls aimed directly at foreigners. He questioned the effectiveness of reserve accumulation. Kathryn Dominguez discussed the challenges in measuring reserve accumulation and the need to distinguish between passive valuation changes and active management of the assets. She showed that many countries depleted their reserves during the crisis and that this active management helped economies recover.
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