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Saturday, February 9, 2013

ECB’s Draghi Resists Pressure to Devalue Euro and Stimulate Growth

Despite pressures from the appreciation of the euro, which had hit a 15-month peak of $1.3711 on February 1, 2013, Mario Draghi of the European Central Bank announced four days later that the benchmark financing rate would be on hold at the record-low 0.75 percent. In making the announcement, he stressed that the worst was over for the Eurozone and that the uncertainties would be gone by midyear. “The economic weakness in the euro area is expected to prevail in the early part of this year. But later in 2013, economic activity should gradually recover, supported by our accommodative monetary policy stance and the improvement in financial market confidence.” Draghi was tacitly undercutting Francois Hollande’s earlier statement that the euro should depreciate so as not to hurt economic competitiveness. A higher euro means more expensive euro-based exports abroad. The relationships between monetary policy, a currency, and economic growth are complex. It would thus be worthwhile to unpack the scenario facing Draghi and Hollande in early 2013.
                         Mario Draghi addressing the World Economic Forum. In resisting pressure to lower the benchmark rate, he increased his financial stature abroad. 
Were Draghi to have lowered the central bank’s benchmark financing rate, which the bank charges to other banks for loans, to say 0.5 percent from 0.75 percent, economic growth could be expected as a result, as banks borrow more than otherwise from the central bank. Whereas the additional economic growth would increase demand for the euro (more economic activity requiring more use of currency), the decrease in the benchmark would (other things equal) reduce the demand for the euro because the interest rates on savings (and checking) accounts would likely decrease too. If there were no comparable interest rate decrease in U.S. dollar and yen-denominated savings accounts, an impact of the ECB’s decrease of 0.25% would be that less interest revenue would come from euro-based accounts. The result even in anticipation would be less demand for the euro. This decrease in demand would tend to be greater than any increase in demand from the sparked economic growth. Therefore, reducing the benchmark rate of the ECB would have increased economic growth and devalued the euro. Francois Hollande would have been jumping for joy.
In resisting the temptation to increase economic growth both directly from decreasing the benchmark rate and indirectly by higher exports from a devalued currency, Draghi was doubtlessly concerned to stave off unnecessary inflation.  The lower the benchmark rate, the higher the risk of inflation of the currency. As more banks borrow more from the central bank, more euros are in use relative to GDP, so the value of each euro is less. Inflation too results in a depreciated currency, and thus higher exports (and economic growth). However, in the long term the added uncertainty brought about by even the fear of inflation reduces investment and thus economic growth.
In keeping the benchmark rate at 0.75%, Draghi was making the prudent judgment that the benefit of any resulting economic growth from a lower rate (and lower euro) would not be worth the added risk of inflation because the prospect was already for a turn-around in the euro-zone in a few months. As if in answer to Hollande of the state of France, the central banker was saying that the E.U. economy could withstand the headwinds of high-priced exports that come from an appreciated currency. It might be added that an industrial policy aimed at exporting premium goods and services could minimize the adverse impact of a strong currency.


ECB Financing Rate on Hold Despite Business Pressures,” Deutsche Welle, February 6, 2013.



Thursday, February 7, 2013

S. & P. Sued for $5 Billion: Breaking a Conflict of Interest?

In sending a message to S & P as well as Wall Street more generally regarding the excesses in the securitization of subprime mortgages that contributed materially to the financial crisis of 2008, the U.S. Government and several state governments announced in early 2013 that they would sue S & P for $5 billion as a penalty and to cover damages to state pension funds and federally-insured banks and credit unions.  The operative assumption was that such a monetary figure would have considerable force as a disincentive to profit by means of fraud.  Would $5 billion be sufficient for the message to be delivered not only S. & P. but also to Wall Street? 
According to U.S. Attorney General Eric Holder, the action “marks an important step forward in the administration’s ongoing effort to investigate—and punish—the conduct that is believed to have [contributed] to the worst economic crisis in recent history.” According to the U.S. Justice department, the subprime mortgages underlying the derivative securities being rated by S  & P were already falling at a high rate in the fall of 2006. Even though some employees at the agency saw this as a red flag, the firm’s policy was to maintain market share rather than lower the high ratings. Simply stated, there was more money in it for S & P with the higher ratings. According to an internal message by one S & P employee in the spring of 2007, “We rate every deal. It could be structured by cows and we would rate it.” The motivation is to maintain market share in the ratings business. Additionally, the rating agency gets a cut every time one of the securities it rates is sold. Because a higher rating will induce more sales, the agency has a financial incentive to rate securities too high.
The $5 billion being sought by the government is more than S. & P. made in 2011. Admittedly, this seems like a strong financial disincentive for rating agencies to commit such fraud again. However, the time value of money alone tells us that the gravity of immediate profit is more than that of even a probably civil penalty. Furthermore, if the bonuses paid out when the profits were rolling in from the subprime-based derivatives are not “clawed back,” it would still be in the financial interest of managers at the rating agencies to overstate the ratings, particularly if the executives have the ability and intent to jump ship in the meantime. “This market is a wildly spinning top which is going to end badly,” one executive at S. & P. wrote in a confidential memo before the financial crisis hit. The obvious play at least for that executive would be to reap the bonuses for as long as possible before getting off the merry-go-round before there’s hell to pay. Let the firm pay the damages, such an executive (and doubtless many others as well) would reason.

                                                                    In being an established institution, S. & P. can make use of the benefit of the doubt.   latimes.com 
Beyond providing the after-the-fact financial disincentive to counter the tremendous profits made in rating the derivative securities too high, admitting to the wrong-doing could be of value. In particular, not being able to count on simply paying civil damages and penalties without having to admit guilt could dissuade rating agencies from overstating ratings for immediate profits in the future. The reason is that reputation is known to be related to long term profitability. Additionally, the admission of guilt, whether voluntarily or in a verdict, would make the underlying institutional conflict of interest more transparent societally.
The face value of an institution’s denial can have considerable credibility societally. Consider the disavowal of S. & P.: “Claims that we deliberately kept ratings high when we knew they should be lower are simply not true. S.&P. has always been committed to serving the interests of investors and all market participants by providing independent opinions on creditworthiness based on available information. Claims that we deliberately kept ratings high when we knew they should be lower are simply not true. S.&P. has always been committed to serving the interests of investors and all market participants by providing independent opinions on creditworthiness based on available information.” There is no mention of the countervailing financial incentive to the rating agency wherein it stands to gain more revenue and market share from the increased sales of a security rated even too high. Prime facie, a business is oriented to making money. Asseverations not in line with it are mere public relations meant to retain a viable reputation in line with making still more money.
Denial as to institutional conflicts of interest begins with naivety on the role of financial inducements in business. Were S. & P. declared guilty in a verdict or to voluntarily admit guilt, the denial would take a hit because the hegemony of the immediate financial interest to the firm would be confirmed publically to be at the expense of the firm’s stated mission to investors and the public. It is indeed all too easy for people to take the rating agency’s claim that it is oriented to the “investor-interest” at face value, as if the agency’s own source of revenue were a mere afterthought. One key to beginning to make such a conflict of interest transparent is for the offending companies to admit wrong-doing or be found guilty.
Fortunately, the U.S. Justice department insisted during settlement talks that S & P admit to wrong doing in at least one of the counts of fraud. That this demand was in part behind the break down in settlement talks suggests how important public denial is to a company and how vital it is to the rest of us that the pattern of being able to obviate admitting any wrong-doing be broken.  Indeed, the wrong-doing should ideally be tied not only to S. & P., but also to particular managers who were involved in the fraud. Regarding them, criminal prosecution would be an effective deterrent.
In short, a multi-pronged approach could be used by the U.S. Department of Justice (as well as departments of various state governments) in making sure that managers that exploit institutional conflicts of interest have a countervailing disincentive, financial and otherwise. Moreover, public policy is needed to decouple the conflicting roles in institutional conflicts of interest. Beyond creating disincentives, the problematic roles, such as in making money off rating securities and serving investors, can be severed not only in the case of rating agencies, but for public accounting firms as well. We as a society need not tolerate such conflicts of interest. The immediate challenge is simply in making them transparent. For scholars, the question to ponder may be why we as a society are so blind to them, whereas we immediately go after individuals who are exploiting a personal conflict of interest (e.g., bribery). Are we so in love with institutions that we look the other way when they are at the nexus of a conflict of interest?  At the very least, we are selective enablers.


Mary W. Walsh and Ron Nixon, “Case Details Internal Tension at S. & P. Over Subprime Problems,” The New York Times, February 5, 2013.

Wednesday, February 6, 2013

Is a Stronger Euro in Europe’s Interest? In America’s?

Speaking at the European Parliament in early February 2013, Francois Hollande of France castigated the floating exchange rate of the euro. “The euro should not fluctuate according to the mood of the markets. A monetary zone must have an exchange rate policy. If not it will be subjected to an exchange rate that does not reflect the real state of the economy.”  The week before, the euro was at $1.37, a 15-month high. The euro was at its strongest rate against the Japanese yen since April 2010. Behind the rise in the currency’s value was a surge in investor interest in the euro from assessments that the worst of the debt crisis had passed. Hollande’s statement can be critiqued on a number of points.
First, a floating mechanism is an exchange rate policy. It was not as though the ECB did not have one merely because it was that of “float” rather than “fixed” or “pegged.” Second, it is by no means certain that a fixed or even a managed-float would reflect the underlying condition of the economy. Third, the increasing value of the euro reflects increasing confidence in the euro-zone, which is not by any means a bad thing for Europe.
                                          Was the upswing in the value of the euro just the beginning of the currency's rise as a reserve currency around the world?
Hollande was concerned that the increasing value of the euro would hurt exports by rendering them more expensive in other currencies. Just as the E.U. was trying to claw back out of a deep recessionary hole, the prospect of declining exports could make the climb out all the more difficult. “We need to protect our interests,” Hollande said. Meanwhile, however, Philipp Rösler, Germany’s vice-chancellor and economy minister, said the eurozone’s top priority should be “strengthening competitiveness, rather than weakening the currency.” This assumes that increasing competitiveness could withstand the headwinds of a strong currency. The added difficulty, he was no doubt assuming, would be preferable to a weak euro as investors continue to steer clear of the eurozone. Put another way, the vote of confidence is on balance a good thing for the E.U., even if it means having to push harder on structural reforms to more than compensate for the new headwinds.
The return to health of the euro can be viewed in a “bigger picture,” which also argues against Hollande’s stance. Namely, a stronger euro even before the bailout had ended may suggest that the currency could eventually compete with, or even replace the U.S. dollar as the main reserve currency globally. With a federal public debt of nearly $17 trillion at the time (plus the debts of the American states), the dollar could already be viewed as vulnerable. The vote of confidence of investors in the euro could eventually exploit this vulnerability.  Politically, if the E.U. moves to establish a balance between the power of the states and that of the union, that federal system will be much healthier than the nearly-consolidated American federal system. With a more balanced federal system and a currency to rival the dollar, the E.U., not the U.S., could be in a position to take on the “Asian century.”
By implication, whether a stronger E.U. is in the interest of the U.S. is a complicated question. Perhaps just as it is advisable that the E.U. move toward balance federally, the American interest is that the E.U. strengthen more—but only so much—relative to the European state governments. Put another way, even though it is in the American interest that the euro not be called into question by investors, the Americans would not want to see the euro rival the dollar as the reserve currency. For there are certain advantages that come with being the definitive reserve currency around the world, such as being able to artificially sustain and even increase a huge public debt. In a sense, Hollande was serving the American interest more than that of the E.U. by pushing to keep the euro from strengthening any more. Put another way, he wanted to trade economic growth for more long-term intangible assets.


Hugh Carnegy and Alice Ross, “Hollande Warns on Euro Strength,” The Financial Times, February 5, 2013.


Tuesday, February 5, 2013

Is the E.U. More Than the Sum of Its Parts?

In the wake of David Cameron’s announcement that he would try to renegotiate Britain’s obligations in the E.U. then have an “in or out” referendum in his state on whether it should secede from the Union, Francois Hollande of France warned that state interests were in the process of usurping “the European interest.” According to the French president, Cameron was heading the E.U. down the path in which each state “looks for what is good for itself and only itself.” As such, the Union would simply be an aggregation of state interests. The question is perhaps the old one of whether the whole is more than the sum of the parts. In proffering different answers, the European federalists and anti-federalists (or Euro-skeptics) have fundamentally different conceptions of what the E.U. is.
Is the E.U. simply an aggregation of all of its states? Or is there a European whole that is distinct?               (source: mapperywordpress.com)
The full essay is at "E.U. & U.S."

Monday, February 4, 2013

Fixing the Foreclosing Banks: A Hidden Conflict of Interest in Regulatory Compliance

After the financial crisis of 2008, regulators in the U.S. ordered banks to hire consultants to implement more than 130 “enforcement actions,” which represent 15% of the cases. In 2011 alone, regulators mandated that eleven banks hire consultants to determine whether mortgage borrowers had been wrongfully evicted. The consultants collected about $2 billion in fees, which amount to more than half of what homeowners were to receive under the $8.5 billion settlement that ended the consultants’ work. According to regulators, the consultants’ work was plagued with inefficiencies. This is probably the least of it, for virtually any expectations for “an industry that is paid billions of dollars by the same banks it is expected to police” are bound to be chimerical in nature.
When the Office of the Comptroller of the Currency penalized JP Morgan Chase in early 2013 for flaws in the bank’s money-laundering controls, the regulator ordered the bank to hire a consultant with “specialized experience” in money laundering and without any conflict of interest. Yet with the bank hiring the consultant, a conflict of interest is thereby incurred.  “How can you be independent if you’re hired by the entity you’re reviewing?” Senator Jack Reed, Democrat of Rhode Island, asked. According to the New York Times, some “banks that work with consultants continue to run afoul of the law. At other times, consultants underestimate the extent of the misdeeds or facilitate them, preventing regulators from holding institutions accountable.” In other words, the bankers who hire the consultants must have the sense that their banks can continue to get away with the bad practices. Meanwhile, the consultants have a disincentive—from having been hired by the banks—in finding the hands that are feeding them at all culpable.
Besides the conflict of interest simply in being hired and paid by the banks, some of the consultants tolerated a conflict of interest in terms of connections. For example, in spite of the comptroller’s office insisting that its staff had vetted the consultants to spot conflicts of interest (an approach that implicitly ignores the conflict of interest in the banks hiring and paying the consultants!), Deloitte, which was allowed to be hired by JPMorgan, had previously audited Washington Mutual and Bear Stearns. JP Morgan had acquired those two firms during the financial crisis. When HSBC was sanctioned in 2003 regarding its money-laundering controls, the bank hired Deloitte to review compliance. Unfortunately, Deloitte had also worked for HSBC from 2006 to 2008 to build a system to monitor money flows more effectively. Deloitte could hardly be an objective critique of the system that it had instituted. That Deloitte has been suspected of helping institutions cloak illicit transfers of money to rogue nations suggests that the comptroller’s office did not exactly perform due diligence in obviating potential conflicts of interest.
Lest it be assumed that the operative conflict of interest is limited to previous roles or even a bad track record, Sen. Reed’s question bears particular emphasis: “How can you be independent if you’re hired by the entity you’re reviewing?” Astonishingly, this perceptive question effectively discredits the entire public accounting industry, for CPA firms are hired and paid by the companies that the CPAs independently audit.  Sen. Reed’s question says, in effect, that the audits cannot be independent under the system as it is designed. In other words, the system itself is problematic, so something stronger than reform is needed if the deep conflict of interest is to be eradicated from the roots up.
In pointing to the faulty job of the office of the comptroller in spotting conflicts of interest, my intent was to make the point that we are not very good at spotting institutional conflicts of interest. The “biggie” right in front of us goes virtually unnoticed and the CPA industry is presumed to have been fixed. Doubtless we will be surprised the next time a CPA firm’s audit is found to be too “friendly” or even enabling at the expense of the public’s interest. We tend to go from incident to incident, totally missing fundamental structural flaws in business and government. It is as though we were accustomed to looking only a little distance ahead while driving. No one is tasked specifically even with making systemic or structural conflicts of interest transparent, let alone with fixing them.


 Jessica Silver-Greenberg and Ben Protess, “Doubt Is Cast on Firms Hired to Help Banks,” The New York Times, January 31, 2013.


Sunday, February 3, 2013

Making Egypt More Democratic: Interiorizing Protests

How a democratic system is designed can be as important as whether the government officials have been elected or appointed. In constructing a democracy, it is not sufficient to simply hold elections. While the victors may have democratic legitimacy, the government itself may still not. Egypt amid the violent protests in early 2013 may be a case in point. Even though unlike in 2012 the sitting president had been democratically elected, it is too simplistic to say that the Egyptian government and constitution had democratic legitimacy.
In January 2013 following an Egyptian court sentencing 21 residents in Port Said to death for their roles in the stadium disaster, the chief of the army said that the ongoing violence could bring about the collapse of Morsi’s government. The opposition demanded that the president establish a nationally unified government and rewrite controversial parts of the constitution that had recently been passed. That the constitution had been pushed by religionists amid an increasingly polarized citizenry left even the democratically elected government vulnerable. It was not enough that Morsi had been democratically elected.
Particularly in a highly polarized country, simply holding elections is not sufficient to usher in a sustainable democracy. If a partisan party holds virtually all of the power in the government of a highly polarized country, the opposition will have no recourse but to resort to protests and even violence. Put another way, democratic legitimacy requires more where a citizenry is polarized in the sense of operating under very different, and thus highly conflicting, assumptions and prescriptions. In such a context, a democratic system that hands virtually all the power over to one “side” is insufficiently democratic.
This is not to say that a “unity government” is the answer. Given the polarization, any unity would be illusory. More realistically, Morsi could have viewed the sheer intensity of the violence in the protests as an indication that the new democratic system was being monopolized by one party at the expense of others. Providing them with their own bases of power within the government and democratically elected would bring in the external political strife—replacing violence on the streets with debate and negotiation between governmental institutions. The latter is not predicated on unity. Even any resulting compromise in legislative terms would not necessarily imply unity.

                                    Can such intense violence be "interiorized" as debate and politics in a legislature?  Government itself can be viewed as civic violence "redacted" and "refined."   Source: thestar.com
Interiorizing the conflict on the streets by permitting it with some political power within the government could be accomplished through a bicameral legislature, the chambers of which having very different bases of membership, or a qualified majority vote mechanism in a single chamber. The separation of powers could also be by government branch, with one party controlling one branch and the opposition controlling at least part of another branch.
In the U.S., for example, a Democrat controlled the White House at the time, while the Republicans controlled the U.S. House. The opposition did not have to have a share of the power in the House because the minority there had another power base within the government. Were the government completely dominated by even democratically elected Republicans, such was the case in Wisconsin after the election of 2010, activist Democrats would head for the streets. That the legitimacy of such a government can quickly become suspect in spite of its democratic basis is illustrated by the thirteen senators from Wisconsin who literally fled to Illinois so Wisconsin’s senate could not function with a quorum. Democracy involves the design of a government as much as that crucial offices are elected rather than appointed. To be legitimate democratically, the government’s design should interiorize political strife by providing a power base to more than one party.
In short, it is not sufficient for the Egyptian president and even its parliament to be democratically elected, such that one party can dominate both simply due to the numbers. Given the extent of polarization among the citizenry, such domination is doomed to failure even if the dominated party is in no hurry to differentiate power-bases within the government. Particularly in cases such as Egypt where the parties are “not on the same page,” the opposition must have some basis within the government to act as a check and thus balance out the otherwise excess possible in one-party rule. In a polarized citizenry, such excess quickly pushes the other side to extreme reactions on the street.
The task in the construction of a viable government in Egypt would seem to be providing opposition groups with enough ownership within the government without thereby providing a veto on any legislative output. As of early 2013 at least, Egypt might have to go a couple of rounds before a design is adopted that effectively interiorizes the violence.  Otherwise, splitting the country into two—one secular and the other a theocracy—might be the only viable solution (other than federalism and the sort of democratic design discussed here).  It is notoriously difficult to relocate people, however, so as to have truly distinct secular and religionist societies. Given the daylight between the two camps, however, partition, such as that which had occurred between Pakistan and India in 1947 might simply reflect the fact that two distinct nations had already come to exist in Egypt. If so, it is the fossilized nature of a defined country that may be the underlying obstacle to Egypt catching up with itself.

Egypt Political Factions Condemn Violence, Urge Dialogue,” Deutsche Welle, January 31, 2013.