Free exchange is worried that the Obama Administration wants to change too much:

WHEN asked my assessment of the government’s handling of the financial crisis, I usually say it is too soon to tell. But I am very concerned it is doing too much, too soon and too fast. Their current agenda (not even an exhaustive list): fix financial markets, boost aggregate demand, set up a new regulatory framework, decide how much bankers should be paid, create a market for green technology, repair infrastructure, repair schools, and fix entitlements. That would be ambitious for God to achieve, even given eight days, let alone mere mortals.

Simon Johnson is worried that the US is doing too little, and thus won’t make the kind of fundamental reforms that the United States needs:

“The financial crisis is abating – although the economic costs continue to mount and new problems may still appear (ask California or Ukraine). At least among the people I talk with on Capitol Hill, there is a very real sense that business is returning to usual; certainly, the lobbyists are out in force, they want what they always want, and it’s hard to see many of them as seriously weakened. How much progress have we made on any of [Rahm] Emanuel’s priority areas or, for that matter, along any other public policy dimension that was previously stuck? The charitable answer would be: this is still a work in progress and you cannot expect miracles overnight. True, but Rahm’s Doctrine .. says that you should implement irreversible change while you still have the chance. Tell me if I missed something, but has there been any breakthrough of any kind?”

A lot of current economic policy debates seem to have a similar character.

The debate over US monetary and fiscal policy, for example.

Is the US macroeconomic response to the crisis too modest (in part because nominal rates cannot go below zero), putting the US at risk of sustained deflation and a prolonged period of subpar growth? Or is it too aggressive, and thus creating a major risk of inflation?

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“Banking is the industry that failed. Banks are meant to allocate capital to businesses and consumers efficiently; instead, they ladled credit to anyone who wanted it. Banks are supposed to make money by skilfully managing the risk of transforming short-term debt into long-term loans; instead, they were undone by it. They are supposed to expedite the flow of credit through economies; instead, they ended up blocking it. The costs of this failure are massive. Frantic efforts by governments to save their financial systems and buoy their economies will do long-term damage to public finances. The IMF reckons that average government debt for the richer G20 countries will exceed 100% of GDP in 2014, up from 70% in 2000 and just 40% in 1980.”

The Nation? Nope. The Economist. Andrew Palmer of the Economist to be precise.

Now that the IMF estimates that the losses from the last credit boom will be close to $4 trillion — with two thirds of the losses coming from the world’s banks — it is rather hard to argue with him.

Yet only two years ago, the financial system of the US — and for that matter the UK — were the envy of much of the world.

Securitization was thought to have protected the core of the financial system from the risks associated with the rup-up in home prices (see paragraph 5 on p. 8 of the IMF’s 2007 assessment of the US) China, as Peter Goodman reminds us, wanted to import Anglo-Saxon financial know-how to help strengthen its banks.

Some things haven’t changed over the past couple of years, but an awful lot has.

Discussions of China’s role in the world that aren’t dominated by economists often end up focusing on China’s willingness to act as a “responsible stakeholder” in the global system. That is diplomatic code for China to do more to support the current international financial and political order that it has — in this view — helped support China’s rapid development.

This framing though assumes something that I am not sure is true, namely that there is a deep consensus on what constitutes a stable international financial order and thus consensus on what China needs to do if it wants to integrate more fully into this order.

The current order, after all, isn’t really defined just by existing institutions like the IMF; the key questions go far beyond China’s willingness to contribute more to the IMF in exchange for a few more votes.

To put it concretely, is a stable international financial order one defined by large-scale Chinese financing of the US, in dollars, to sustain a large US current account deficit – whether one that reflects a large deficit among US households or a large US fiscal deficit?

Or is a stable financial order marked by floating exchange rates among the world’s major economies, limited build-up of reserves and modest current account deficits (and surpluses)?

In the first conception of global financial order, China should continue to peg to the dollar, adopt policies that restrain domestic demand growth to avoid domestic inflation if the dollar is weak and run up large dollar reserves. That policy mix would produce large current account surpluses – and allow China’s government to continue to provide large amounts of financing to the United States. Call it Bretton Woods 2 bis. China’s current $1.5 trillion or so dollar portfolio would double over the next four years, to about $3 trillion – and keep on rising after that. The current crisis doesn’t – according to this view – signal that there is anything fundamentally wrong with a world where a poor country like China finances a rich country through the United States as a result of a policy of holding its exchange rate down to support its export sector. See Michael Dooley and Peter Garber for a forceful statement of this view combined with plenty of sharp criticism of those who have criticized Bretton Woods 2.

In the second conception of global financial order, China should allow its currency to appreciate, offset the drag from slower growth of exports with aggressive policies to stimulate domestic demand (including the rapid implementation of a broad social safety net, even if this produces sustained budget deficits) and bring its current account surplus down. China’s government would no longer steadily accumulate large quantities of dollar reserves. More balanced trade flows would allow the RMB to eventually float – allowing China to direct domestic monetary policy toward stabilizing China’s own economy rather than stabilizing its exchange rate.

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I tend to agree with the FT’s leaders – especially their leaders on the world’s macroeconomic imbalances — more often than naught. But not always. On Friday an FT leader warned about the risk of financial deglobalization:

“Finance is deglobalising out of fear and because of national policies. Neither will be fully undone without political choices that look unlikely, at least for now …. But unless policymakers come up with better global regulation that works we may have to settle for permanently less globalised finance.” (emphasis added)

That didn’t ring true to me. At least not fully. The tone of the leader seemed to long for a return of the pre-crisis world, one where huge quantities of funds flowed across borders, albeit one with better global regulation. Yet just as trade probably rose to a level that could only be supported if US households continued to run up an unsustainable level of debt, cross-border financial flows likely reached levels that could only be sustained if the global financial system remained over-leveraged.

The goal shouldn’t be to return the boom years, but rather to return to a more sustainable level of cross-border flows — or at least a system without the excesses that contributed to the current crisis. Remember, the rise in cross-border capital flows prior to the crisis was associated with a rise in the amount of leverage in the system, as a host of institutions tried to support bigger balance sheets without increasing their equity. That rise in leverage sustained a lot of cross border flows.

To be concrete:

US financial institutions sponsored offshore special investment vehicles (SIVs) that often borrowed short-term from American investors to buy longer-term US debt. They were offshore largely because they were off balance sheet. If the same activity had been performed on the banks domestic balance sheet – with more short-term wholesale borrowing to support a larger securities book – cross-border flows would fall. But regulators also would have had a lot more information about the build-up of risks in the global system. Taxpayers might not think that is a bad thing.

European institutions seem to have been supporting bigger dollar balance sheets than they could finance entirely in the offshore “euro-dollar” market. Some were borrowing large sums from US money market funds – and then using the proceeds to invest in longer-term US paper. Sometimes securities insured by AIG’s now notorious credit products group, a little trick that allowed the banks to minimize the amount of capital that they had to hold against their dollar book. A bit less of this wouldn’t necessarily be a bad thing. AIG hasn’t worked out so well for the US taxpayer, and the big dollar books of European banks haven’t worked out so well for European taxpayers.

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Yes, my headline is a bit overstated. Panic is too strong. A sudden stop might be a better term. or an (almost) orderly withdrawal. But there is more and more data suggesting that central bank reserve managers added to the stress in the credit markets during the crisis of the fall of 2008.

We have known for a long-time that some central banks shifted from buying huge quantities of US Agency bonds (Fannie, Freddie and the like) to selling fairly large quantities rather suddenly. Big buyers in the second quarter of 2008 were big sellers in the fourth quarter of 2008. And we now know that the world’s reserve managers pulled a fair amount of liquidity out of the international banking system in the fourth quarter as well.

The BIS data (table 5c) suggests that central banks pulled about $200 billion ($192.6 billion to be exact, summing “domestic” and “foreign” currency liabilities to monetary authorities) from the world’s big banks in the fourth quarter. Their euro deposits fell too, by almost $60 billion ($57.6 billion). That no doubt added to the pressure on the dollar liquidity of Europe’s banks: US money market funds and the world big central banks were pulling dollars out simultaneously.

The Fed and Europe’s central banks filled the breach, with their swap lines.

To be clear, when a country’s reserves fall, it has to run down its foreign assets — whether its holdings of Treasuries, its holdings of Agencies or its deposits with large banks. Emerging economies that ran down their reserves to — in effect — finance either capital outflows from their own country or to cover a current account deficit were helping to stabilize the system.

Think of it this way: some central banks ran down their deposits in the world’s banks to help their private banks repay the same international banks. That is stabilizing.

However, that wasn’t all that was going on. Global reserves were down by around $200 billion (my estimate, based on the COFER data) in q4, and dollar reserves were down something like $150 billion.

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Barry Eichengreen writes exceptionally well:

“THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed “Great Moderation.” We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.

We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over.”

What went wrong? Eichengreen argues that those who wanted to take big financial risks were biased toward theories that supporting taking big financial risks.

“the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking”

That seems generally right.

Especially as those who tend to be better at seeing risks than opportunities tend to warn of trouble well before it breaks out, and even if they identify certain underlying vulnerabilities, are unlikely to call every move in the market.

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That isn’t a question that is usually asked in the debate about the “right” size of the IMF. But it strikes me as a question worth asking.

Back in 2006, US growth slowed relative to growth in the world. Private demand for US assets fell.* But the US didn’t have to “adjust” — that is to say bring its trade deficit down to reflect the reduced availability of private financing. Why not? Emerging economies, who received most of the influx of private money not going to the US, generally used this influx to build up their reserves. A rise in financing from central banks and sovereign funds offset the fall in (net) private demand for US assets.** The US trade deficit fell a bit relative to US GDP, but not by all that much.

Thanks to a generous supply of credit from the emerging world’s central banks, the party kept going long after private investors ceased to be willing to finance it.

Suffice to say that when emerging economies running comparable deficits to the US encounter a comparable fall off in private financial flows, the amount of financing that gets recycled back their way by the US and EU (through institutions like the IMF) is far smaller. Between 1997 and 1999, “volatile” private capital flows (bank loans and portfolio flows, I left FDI out) swung from a $100 billion inflow to a $100 billion outflow. The net increase in IMF’s lending over this time by contrast was only around $30b — not all that much relative to the $200 billion swing.

The current crisis isn’t all that different. Between 2007 and 2009, volatile capital flows are expected to fall from a positive $250 billion to a negative $400 billion — a swing over over $650 billion. IMF lending — based on all existing programs — will increase by close to $120 billion (see this chart by my colleague Paul Swartz). That is more than in the past, but not enough to offset the fall in capital flows, and certainly not enough to offset the combined impact of lower capital flows and lower commodity prices on the commodity exporting region.

Scaled to world GDP, the current swing in private capital flows and the (projected) rise in official lending looks roughly similar to the swing back in 97-98.

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One issue to watch over the next few days, as the world’s finance ministers gather for the IMF’s spring meetings: whether or not the G-20 (and other) countries carry through on their pledge to expand the resources available to the IMF.

The IMF cannot supply credit to a host of troubled emerging markets unless it gets credit (via its supplementary credit line, or a bond issue sold to key central banks with excess reserves) from a bunch of countries in a (somewhat) stronger financial position.

But also give the IMF credit for producing analysis that has become an essential guide to the current crisis. Like Dr. Krugman, I am eagerly awaiting the release of first few chapters of the WEO tomorrow. That is something that I couldn’t have credibly said all that often in the past. The detailed WEO will provide a baseline, among other things, for assessing whether the fall in the world’s macroeconomic imbalances in the first quarter can be expected to persist for this year, and for the next.

The IMF’s Global Financial Stability Report – released today – already provides a baseline for assessing the scale of the losses that the last credit cycle will generate (gulp, over $4 trillion, with $2.8 trillion from the US – two times as much as the IMF forecast in October) and thus, in broad terms, the scale of the new capital the financial sector needs.

This crisis challenged the IMF. A truly global crisis calls out for a global response, underpinned by high-quality global analysis. A few years back, the IMF’s surveillance wasn’t perhaps as focused on the underlying risks of an unbalanced and highly leveraged world as it should have been. Just look at the IMF’s 2007 economic health check for the US , which declared – a minus a caveat or two – that the core of the US financial sector was well capitalized and “relatively protected from credit risk” (see paragraph 5, on p 10 of the staff report/ and paragraph 5 of the PIN/ ). Oops.

Of course, the IMF’s assessment of the US financial sector echoed the conventional wisdom of the time. And, in other areas, the IMF can credibly argue that it highlighted risks that others wanted to ignore. It, for example, consistently called attention to the build-up of balance sheet risk in emerging Europe.

Suffice to say that the IMF didn’t risk making the same mistake in its current Global Financial Stability Report. Chapter 1 of the Global Financial Stability Report makes for sobering reading.

The IMF paints a picture of a global economy where neither large financial institutions in the world’s economic and financial core nor those emerging market governments with large external financing needs can count on financing themselves in private markets. Both sets of borrowers, in effect, now rely on the support of official institutions, whether the IMF, the the world’s large central banks or taxpayers. The financial sector relies on official support for the money it can no longer raise in the “wholesale” funding market*, and emerging markets to offset the withdrawal of cross-border bank lending.

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Tyler Durden/ Zero Hedge’s analysis of the aggregate balance sheet of the US commercial banks attracted a lot of attention last week, for good reason (h/t Felix Salmon).

American taxpayers are – in various ways – stabilized the US financial system by putting equity into a host of troubled banks, lending liquidity constrained banks a lot of money and guaranteeing a decent fraction of the banking system’s liabilities. And there is still a lot of uncertainly about the ultimate cost to the taxpayer of all these policies, as the “true” state of the banks’ balance sheet isn’t yet known – and in some sense cannot be known, as the cash flows underlying a host of financial assets themselves are a function of the economy.*

I though was struck my something else. Data on the US banks seems to miss a large chunk of the US banking system.

Total liabilities of US banks, according to Zero hedge, are close to $12 trillion.

The dollar liabilities of Europe’s banks are – according to the BIS — about $8 trillion. UK banks alone had a gross dollar balance sheet of close to $2 trillion. For details, see the charts on p. 2 and p. 51 of the latest BIS quarterly.

There may be some double counting. And European banks make dollar loans to non-US borrowers, so they aren’t just lending in dollars to the US. But the data – on face value, without any adjustment – suggests that US banks might only account for only about 60% of the aggregate dollar balance sheet of the world’s commercial banks.

But the Fed’s flow of funds data suggests that there isn’t a lot of double counting. The liabilities of US-charted banks at the end of q4 totaled $9.9 trillion, with US bank holding companies accounting for an additional trillion dollars of debt. Foreign banking offices in the US had by contrast $1.6 trillion in liabilities (see tables L 110-112), far less than the $8 trillion in dollar balance sheet of the European banks.** There is little doubt that many of the world’s large dollar balance sheets aren’t regulated by the US – and aren’t going to be bailed out by the US taxpayer.

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About three months ago, the editors of Finance and Development (an IMF publication) asked me to reflect on the lessons the effort to reform the international financial architecture in the 1990s holds for today’s effort to reform the global financial system. Then, as now, there was a real desire to create a system that was less prone to major crises — though the financial crises of the late 1990s were concentrated in the emerging economies, not the US and Europe.

One of my conclusions was that summits rarely are the venue for the key decisions that end up defining the character of the world’s financial system. Many of the decisions that ended up mattering the most were fundamentally national decisions. Other key decisions were made in the heat of an acute crisis — not in a conference room hashing out communique language.

Three examples:

The US decision to provide Mexico with a large loan to avoid default in 1995, for example, had a bigger impact on the global regime for responding to acute financial crises in emerging economies than any subsequent communique. The US decision ended up spurring the IMF (with US support) to offer a large loan first to Mexico and then to other emerging economies. Lots of time was spent talking about the need to return to a world of smaller rescue loans, but it never really happened. A new norm had been established. The conditions that the IMF — with the support of the US and the rest of the G-7 — attached to their initial loans to cash-strapped Asian economies in 1997 had an equally profound, though different, impact: even if the IMF was willing to lend more than in the past, no emerging economy wanted to be subject to the IMF’s conditions if there was a realistic alternative.

The global exchange rate system of the past decade was defined by China’s decision to stick to its dollar peg. That fundamentally was a national decision — though one that had profound consequences for the system. If China hadn’t followed the dollar down from 2002 to 2005, China’s current account surplus wouldn’t have grown as large as it did, China’s reserves wouldn’t be as large as they are and China’s economy wouldn’t be as dependent on exports as it is.

The system of global financial regulation was defined by a deep reluctance by key nations to regulate financial institutions too tightly — an unwillingness, incidentally, that was shared by both the US and Europe. Markets were trusted more than regulators, and no one wanted to lose financial business to a rival financial center. Alas, the financial system ended up extending ever-more credit against ever-higher real estate values without a corresponding increase in the capital needed to absorb downside risks.

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