The cautious approach to fixing banks will not work

By Martin Wolf
Published: June 30 2009 20:03 Financial Times

With one bound the banks are free, or so it seems. Already, the panic of the autumn of 2008 is fading. The period within which lessons can be learnt and changes made is closing. Yet without radical changes, another crisis is certain. It may not even be that long delayed.

In a recent speech, governor Elizabeth Duke of the Federal Reserve told an anecdote from just after the failure of Lehman Brothers last September. Ben Bernanke, chairman of the Federal Reserve, was asked: “Well, what if we don’t do anything?” To which he replied: “There will be no economy on Monday.” Instead, all institutions deemed systemically significant were saved, by shifting almost all of the risk on to taxpayers.

“Never again” might be too much to ask. But “not for a generation” is essential. Governments cannot afford an early repeat, financially, politically, perhaps morally: the lives of so many cannot soon be sacrificed to the whims of a foolish few.

Yet what has emerged after the crisis is, as I argued last week , an even worse financial system than the one with which we began. The survivors are an oligopoly of “too-big-and-interconnected-to-fail” financial behemoths. They are the winners not because they are necessarily the best businesses, but because they are the best supported. It takes no imagination to realise what these institutions might now do, given the incentives for risk-taking.

So what is to be done? The characteristic, but futile, response is to move the regulatory deckchairs on the deck of the Titanic. Recent proposals from the US Treasury fall partly into this category. But the financial system had to be rescued from its own mismanagement of risk. This is not going to be changed by external supervision. It is going to be changed only by fixing incentives.

The starting point has to be with “too big to fail”. We need a credible system for winding up even huge financial institutions. The most attractive proposals are for “good banks”, in which unsecured creditors become shareholders. That would be easier if, as President Barack Obama has proposed, and Mervyn King, governor of the Bank of England, has argued, a regulated institution has to produce a plan for an orderly wind-down of its activities.

Yet bank failures are like buses: you do not see one for hours and then a fleet arrives together. The authorities cannot make a credible promise that they would be prepared to put all affected institutions through bankruptcy in a systemic crisis. This would be a recipe for still-greater panics. “Too big and interconnected to fail” is a reality. It is so, because, as Andrew Haldane of the Bank of England pointed out in a recent speech, the financial system is an increasingly tight network.*

My colleague John Kay has argued that the right response is to create “narrow banks”, which are perfectly safe, leaving the rest of the financial system to go on its merry way, subject to a then-plausible threat of bankruptcy. I find this idea both attractive and unpersuasive. The attraction seems evident. It is unpersuasive in part because it is so hard to agree on what narrow banks should do. It is also unpersuasive because the narrower the banks are made to be, the more vital is the role of the rest of the financial system and so the less plausible it is that governments would let it collapse.

If institutions are too big and interconnected to fail, and no neat structural solution can be identified, alternatives must be found: much higher capital requirements and greater attention to liquidity are the obvious ones. At present, big financial institutions operate with next to no capital: in the US, the median leverage ratio of commercial banks was 35 to 1 in 2007; in Europe, it was 45 to 1 (see chart). As I noted last week, this makes it rational for shareholders to “go for broke”, with the results we have seen. Allowing institutions to be operated in the interests of shareholders, who supply just 3 per cent of their loanable funds, is insane. Trying to align the interests of management with those of shareholders is then even crazier. With their current capital structure, big financial institutions are a licence to gamble taxpayers’ money.


So how much capital makes sense for systemically significant institutions? “Much more than today” is the answer. Moreover, the required capital must also not be risk-weighted on the basis of banks’ models, which are not to be trusted. Shareholders’ funds should make up a minimum of 10 per cent of capital. In the US, it used to be far higher.

Higher capital is, in addition, a good way to internalise the negative “externalities” – more precisely, risks – created by one institution for the entire system. Ideally, therefore, the required capital should be correlated with the systemic significance of institutions, as the excellent new annual report from the Bank for International Settlements argues. Moreover, the requirement should be set against all activities, on the basis of fully consolidated accounts.

Within a far better capitalised financial system, it would also be relatively easy to operate a “macroprudential” regime, with the required capital rising during booms and falling during busts. Again, the bigger the stake of shareholders, the less one would worry if the rewards of managers were aligned with them. Even so, regulators have to have some sort of control on the incentives of management, as long as taxpayers bear residual risk.

Two difficulties remain: the transition; and regulatory arbitrage.

On the former, a demand for much higher capital ratios today would imperil the recovery. The answer is a lengthy transition, perhaps of as much as a decade. On the latter, it is evident that the so-called “shadow banking” system cannot be allowed to operate outside capital constraints if entities within it are likely to be systemically significant, as proved to be the case for money market funds. Moreover, capital ratios would have to be imposed by all significant countries. But the US is powerful enough to force movement in that direction by insisting that any foreign bank operating within it must be appropriately capitalised.

In sum, deleveraging is the right starting point for a healthier financial system. This would work best if we also eliminated today’s huge fiscal incentives for borrowing.

It is cautious incrementalism, not radicalism, that is now the risky option. Where should such radicalism start? The answer is clear: it is the incentives, stupid.

Germany and France need to sing in tune

By Wolfgang Münchau

Published: June 28 2009 19:20 Financial Times

I never expected a message of austerity to emerge from the Palace of Versailles, where Nicolas Sarkozy, France’s president, spoke last week to outline his economic strategy for the rest of his term. He left no doubt that he is not prepared to follow Angela Merkel, Germany’s chancellor, in the direction of a balanced budget. Instead, he distinguished between “good” and “bad” government deficits, went on to explain that a good deficit is cyclical, a bad deficit structural, and then produced yet another category: a temporary deficit that would be brought down through higher economic growth in the future.

In theory, this is all fine. In practice we have reason to doubt whether he will make an earnest effort to get rid of the deficits, good or bad. One can have endless debates about the relative benefits of Germany’s legalistic approach or Mr Sarkozy’s alternative version. Whatever side of the debate you support, you will probably agree that it is not a good idea for the two largest members of the eurozone to move in opposite directions.

In fact, it could prove highly destabilising to the eurozone. Germany, as I argued last week, is heading in the direction of a zero level of government debt in the long run as a consequence of a new constitutional balanced-budget law. It is perhaps not intuitive that a balanced budget, pursued indefinitely, would eventually lead to a complete eradication of public debt. But this is what will happen.

In fact, Germany’s new law imposes an upper deficit ceiling of 0.35 per cent of gross domestic product over the economic cycle. But remember this is a ceiling. There is no floor. If the cyclically adjusted deficit came in exactly at that ceiling, year after year, and assuming a nominal rate of output growth of 4 per cent, this would stabilise Germany’s debt-to-GDP ratio at just under 10 per cent. So if this constitutional law sticks, Germany’s debt-to-GDP ratio will settle somewhere between zero and 10 per cent in the long run.

Now, Germany is a country with a large current account surplus, or excess of domestic savings over domestic investments – 6.6 per cent of GDP in 2008 and 7.6 per cent the year before. It is no surprise therefore that German banks have been hit so heavily by the securitisation crisis. They had to channel masses of surplus savings abroad. In the event, they bought US subprime mortgages and their derivative products.

They will not repeat the same mistake, but they will still be facing a problem. If Germany’s national debt converges towards zero, Germany’s surplus savers will have to invest huge amounts of their savings outside the country, since the supply of German government bonds will diminish over time as the outstanding stock of debt is depleted.

Now this is where Mr Sarkozy’s bad deficits come in. Most German savers, especially pension funds, will want to invest in euro-denominated government debt, which, for practical purposes in this scenario, means French debt, because no other domestic European bond market is sufficiently large and mature. As a result France may enjoy a version of America’s exorbitant privilege.

If Germany unilaterally goes down the road of deficit reduction, and if France unilaterally goes the opposite way, the result will be a serious imbalance. France will find it progressively easy to finance its public sector deficit, as German savers have no choice but to buy French debt instruments. They will get trapped in French debt, just as the Chinese got trapped in US debt.

This means that Germany will suffer two successive blows. The first is a sacrifice of economic growth as a result of the pro-cyclical policies needed to do away with the deficits for ever. We got a taste of that last week, when Klaus Zimmermann, president of the German Institute for Economic Research, advocated an increase in value added tax from 19 to 25 per cent. Such action would obviously be disastrous for economic growth. It would throw Germany into a full-scale depression. But he is right in a narrow technical sense. If Germany is hell-bent on eliminating its structural deficit by 2016, some drastic measures are inevitable. Ms Merkel has said she will not raise VAT, but she will either have to raise other taxes or cut spending. Politically, the first will be easier than the second.

Once budgetary balance is achieved, at huge economic cost, German savers will then suffer the second blow in the form of poor returns on investment, as their surplus savings will be financing Mr Sarkozy’s good, bad and ugly economic policies.

How long can this go on? Imbalances can last a long time, but they do not last for ever. Something will have to give. It could be that future generations of German politicians find ingenious ways around the balanced budget law. Or that they find a two-thirds majority to overturn it. Or that Mr Sarkozy or his successors follow Germany into a future of austerity. But as long as one of those three events fails to happen, Germany may discover that unilateral fiscal rigour in a monetary union could prove extremely costly.

For the sustainability of the euro, you surely do not want to get into a position where a large member state has a rational economic reason to quit. So if Germany and France really do what they both promise, you may as well start the egg timer.

munchau@eurointelligence.com

Reform of regulation has to start by altering incentives

By Martin Wolf
Published: June 23 2009 20:16 Financial Times

Proposals for reform of financial regulation are now everywhere. The most significant have come from the US, where President Barack Obama’s administration last week put forward a comprehensive, albeit timid, set of ideas. But will such proposals make the system less crisis-prone? My answer is, no. The reason for my pessimism is that the crisis has exacerbated the sector’s weaknesses. It is unlikely that envisaged reforms will offset this danger.

At the heart of the financial industry are highly leveraged businesses. Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely.

The place to start is with the core of modern capitalism: the limited liability, joint-stock company. Big commercial banks were among the most important products of the limited liability revolution. But banks are special sorts of businesses: for them, debt is more than a means of doing business; it is their business. Thus, limited liability is likely to have an exceptionally big impact on their behaviour.

Lucian Bebchuk and Holger Spamann of the Harvard Law School make the big point in an excellent recent paper.* Its focus is on the incentives affecting management. These are hugely important. Still more important, however, is why a limited liability bank, run in the interests of shareholders, is so risky.

In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses. In contemporary banks, leverage of 30 to one is normal. Higher leverage is not rare. As the authors argue, “leveraged bank shareholders have an incentive to increase the volatility of bank assets”.

Think of two business models with the same expected returns: in one these returns are sure and steady; in the other the outcome consists of lengthy periods of high returns and the occasional catastrophic loss. Rational shareholders will prefer the latter. This is what one sees: high equity returns, by the standards of other established businesses, and occasional wipe-outs.

Profs Bebchuk and Spamann add that four features of the modern financial system make the situation even worse: first, the capital of banks is itself partly funded by debt; second, the role of bank holding companies may further increase the incentives of shareholders to underplay risk; third, managers are rewarded for aligning their interests with those of shareholders; and, fourth, some of the ways managers are rewarded – options, for example – are themselves a geared play on rewards to shareholders. So managers have an even bigger economic interest in “going for broke” or “betting the bank” than shareholders. As the paper notes, the fact that some managers lost a great deal of money does not demonstrate they were foolish to make these bets, since their upside was so huge.

A solution seems evident: let creditors lose. Rational creditors would then charge a premium for lending to higher-risk operations, leading to lower levels of leverage. One objection is that creditors may be ill-informed about the risks being run by banks they are lending to. But there is a more forceful objection: many creditors are protected by insurance backed by governments. Such insurance is motivated by the importance of financial institutions as sources of credit, on the asset side, and suppliers of money, on the liability side. As a result, creditors have little interest in the quality of a bank’s assets or in its strategy. They appear to have lent to a bank. In reality, they have lent to the state.

The big lesson of the current crisis is just how far such insurance may go in the case of institutions deemed too big or interconnected to fail. Big banks rarely get into trouble in isolation: they often make very similar errors; moreover, the failure of one impairs the actual (or perceived) solvency of others. Thus, creditors are most at risk in a systemic crisis. But a systemic crisis is precisely when governments feel compelled to come to the rescue, as they did at the end of last year.

According to the International Monetary Fund’s latest Global Financial Stability Report, support offered by the US, UK and eurozone central banks and governments has amounted to $9,000bn (€6,400bn, £5,500bn), of which $4,500bn are guarantees. The balance sheet of the state was put behind the banks. This does not mean creditors bear no risk at all. But their risk is attenuated.

The well-known solution is to regulate such insured institutions very tightly. But an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the “shadow banking system” itself – was to find a way round regulation. The obvious question is whether it will be “different this time”. Sensible people must doubt it. Indeed, it must be particularly unlikely when the capitalisation of banks is so small. This is the time to go for broke.

In a speech delivered just last week, Mervyn King, governor of the Bank of England, made clear why finding a better approach matters so much: “The costs of this crisis are not to be measured simply in terms of its impact on public finances, the destruction of wealth and the number of jobs lost. They are also to be seen in the lost trust in the financial sector among other parts of our economy ... ‘My word is my bond’ are old words. ‘My word is my CDO-squared’ will never catch on.”

Such a crisis is not only the result of a rational response to incentives. Folly and ignorance play a part. Nor do I believe that bubbles and crises can be eliminated from capitalism. Yet it is hard to believe that the risks being run by huge institutions had nothing to do with incentives. The unpleasant truth is that, today, the incentive to behave in this risky way is, if anything, even bigger than it was before the crisis.

Regulatory reform cannot end with incentives. But it has to start from incentives. A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that.

Pessimistic executives cash out of shares

By Anuj Gangahar and Michael Mackenzie in New York
Published: June 22 2009 23:36 | Financial Times

Growing pessimism about the prospects for a global economic recovery sent stock and commodity prices tumbling on Monday while new data showed that leading US corporate executives were cashing out of their share holdings at a rapid pace.

US government bond yields followed equity prices lower, confounding analysts who had expected that Treasury rates would rise this week as the federal government auctioned off a record $104bn of debt.

Analysts said the market mood was captured by a World Bank report that said the global economy would contract 2.9 per cent this year, compared with a previous estimate of a 1.7 per cent fall. A White House spokesman said later in the day that the US unemployment rate was likely to rise to 10 per cent in the next couple of months.

The downbeat commentary reinforced the view that investors should be more worried about the impact of economic weakness on corporate profits than the possibility of higher inflation and interest rates.

“We have had a great run in equities, emerging market currencies, credit and other risky assets, now people are struggling to justify lofty valuations,” said Alan Ruskin, strategist at RBS Securities. He added: “The ‘green shoots’ argument for the economy was very tentative to start with.”

Executives in charge of the largest US companies sent a signal of their concerns by selling far more shares than they bought this month, according to data based on Securities and Exchange Commission filings.

Share sales by so-called company insiders are outstripping purchases so far this month by more than 22 times. TrimTabs, the investment research company, said insiders of S&P 500 listed companies have unloaded $2.6bn in shares in June, compared with $120m in purchases.

“The smartest players in the US stock market – the top insiders who run public companies – are not betting their own money on an economic recovery,” said Charles Biderman, chief executive of TrimTabs.

The S&P 500 index fell 3.06 per cent to 893.04 – its first close below 900 this month. Analysts noted that the index closed below its 50-day and 200-day moving averages. “This is evidence that the rally since March has been a correction and not necessarily the start of a meaningful multi-year rally,” said Jack Ablin, chief investment officer at Harris Private Bank.

The yield on the 10-year Treasury fell 10 basis points to 3.68 per cent. Crude oil prices fell $2.62, or 3.77 per cent, to $66.93 a barrel.

Earlier, the FTSE Eurofirst 300 index slid 2.6 per cent while London’s FTSE 100 index fell 2.3 per cent. Emerging market equities also fell sharply, with Russia leading the retreat.

Budget Cuts Cast Shadow Over Florida's Universities

By PAUL FAIN

Bad budgets are old news in the Sunshine State. While colleges across the nation are coping with the recession, public universities in Florida, a state with finances that resemble a Ponzi scheme, have spent years doing without.

Ask Paul Outka, an assistant professor in Florida State University's highly regarded English department. But don't call him on his office phone this fall. He won't have one anymore — it's among the latest victims of cost-cutting.

He says he prefers forced frugality to its alternatives.

"You get rid of the phone lines and you save some of my comrades," says Mr. Outka, who has had a ringside seat at one of the worst financial catastrophes in higher education today.

The recession hit Florida early, and in a big way. Without an income tax, state government has long depended on property and sales taxes. As real estate and tourism have tanked, however, the state's annual revenue has shed more than $12-billion from a 2006 peak of $74-billion. But Florida's conservative politicians have remained steadfast in refusing new taxes. They also fought to keep the university system's tuition at rock-bottom levels.

The result for the state's 11 public universities has been cutbacks in state money, which have led to gutted programs, faculty departures, low salaries for professors, and the nation's highest student-to-faculty ratio. University leaders say this is by far the worst chapter in a long history of chronic underfinancing.

Mr. Outka got there just in time for this round. Described as a rising star by colleagues, his hiring was a coup for the university, which lured him away from the University of Virginia in 2007, as the cuts were beginning. In addition to having his phone line removed, Mr. Outka has had to ration his copier paper and sits in a non-air-conditioned office on weekends. He has too many students to meet with any of them individually until at least their junior year, and he never teaches classes smaller than 35 students.

"They wanted us to take out a bulb from our fluorescent lights," he says during an interview in his spartan office. He points to two reams of paper on a shelf and says, "There's my stash."

Yet the anxiety and annoyances have yet to defeat Mr. Outka, who says he can still do his job, and even enjoy it.

His resolve is evidence that while Florida's universities have been battered by the cuts, they have yet to fall apart. A common refrain emerges during visits to Florida State, the University of Florida, and the University of Central Florida: While it may be a miracle, academic quality and student access remain largely intact — so far.

After all, public universities are remarkably resilient.

"It takes a long time for a university to make or lose a national reputation," says Terry L. Hickey, provost of the University of Central Florida.

continue reading at CHE (password required)

Stimulus Money Helps Colleges Avoid Slashing Budgets Now, but Big Cuts May Loom

By ERIC KELDERMAN

This year was bleak for state higher-education budgets. But college leaders are even more worried about what comes next.

The billions of dollars in federal stimulus aid to plug shortfalls in state education budgets have helped limit the damage this year, but the money hasn't prevented all of the cuts to college budgets. Most states are spending the bulk of the stimulus money they are receiving for education on elementary and secondary schools, and roughly 20 percent on public colleges. In one state, Wisconsin, none of that federal aid is going to higher education.

And the situation could get worse. Many states are spending all of their education stimulus money to fill gaps in the current and next budget years, leaving nothing for 2011, when many of their economies are still expected to be suffering from the recession.

As lawmakers and campus leaders contend with the budget crises, some higher-education experts believe the severe scope of this recession will force fundamental changes in how public colleges operate as they struggle to maintain both quality and affordability in an environment of increased competition for tax dollars and students.

"The different sectors within higher education will be reshaped, and changes in instructional delivery and program offerings will be dramatically altered by fiscal realities, market forces, and technological enhancements," said Daniel J. Hurley, director of state relations and policy analysis at the American Association of State Colleges and Universities.

continue reading at CHE (password required)

Letter to Editor about CHE Piece on California Higher Education

Dear Editor,

Your article, "California's 'Gold Standard' for Higher Education Falls Upon Hard Times," does a good job of documenting the startling decline of higher education attainment in California, a decline that may be unprecedented in modern American history. But the discussion of the ins and outs of the Master Plan puts too much weight on a side issue.

The core issue is that California's state government cut its share of higher education budgets 40% between 1990 and 2005 (UC figures, corrected for inflation and enrollment growth) as amply documented in Academic Senate reports, e.g. http://www.universityofcalifornia.edu/senate/reports/AC.Futures.Rpt.0107.pdf. The current cuts will bring this reduction to at least 50%, perhaps closer to 60%. Since undergraduate instruction and related campus activities are far more dependent on state money than is generally realized, these astonishing cuts have redefined UC and CSU in one generation, and are directly responsible for reduced educational attainment.

The real questions for California and other states are these. Do you want to keep paying more to get less - say "only" 10% higher fees per year, with continuous reductions to operations? Do you want to replace all lost state money with fees, and go from $9000 next year at UC to more like $15,000? If you want to do the latter, do you care about the damage this will do to Black and Latino attainment, who are already being failed by continuous cost increases and reduced quality?

California doesn't need to destroy its once-great higher education system, but it needs to understand that the old combination of quality and access depended on strong public funding. Nothing has yet be invented to replace that.

Sincerely,

Christopher Newfield
UC Santa Barbara

California's 'Gold Standard' for Higher Education Falls Upon Hard Times

By JOSH KELLER

San Francisco

Few documents in higher education have enjoyed the influence or longevity of the California Master Plan for Higher Education, the 1960 law that transformed the state's public colleges and served as a blueprint for public systems across the country.

Even today, almost 50 years after it was written, the master plan retains a mythic status in California, where it continues to provide the foundation of public debate about higher education. Californians routinely invoke the plan's promises of minimal fees and universal access as the basis for nearly any argument about the state's colleges.

Oppose tuition increases? Cite the master plan. Decry cuts in state support for student-aid programs? Cite the master plan. Support, or reject, changes in admissions policies at the University of California? Cite the master plan.

But as California grapples with one of the worst financial crises in its history, the master plan faces criticism that it is irrelevant to the needs and means of the state. Many scholars and college leaders argue that the hallowed document that has served the state so well for decades needs to be rewritten.

"There's probably only one thing that's worse than a public policy that fails, and that's a public policy that succeeds and outlives its usefulness," says Patrick M. Callan, president of the National Center for Public Policy and Higher Education, in San Jose, Calif.

By any measure, California's colleges are still some of the most diverse and highest-quality public institutions in the country. But Mr. Callan and others point to indications that the state's higher-education system, once the gold standard for institutions from community colleges to research universities across the country, is having trouble adapting to California's changing needs.

Compared with other states, California's educational capital is declining, a phenomenon that predates the current recession. In 1990, California ranked 17th in the proportion of its residents ages 25 to 34 who hold bachelor's degrees or higher. By 2007 it ranked 25th, well below other big states like New York, Illinois, and Virginia. (See box at end of article.)

In a report often cited by college leaders, the Public Policy Institute of California estimated this year that the state would fall one million college graduates short of its work-force needs by 2025. The nonprofit group's report suggested that the state's inability to move through college enough Hispanic residents, its fastest-growing group, was a key cause of the shortfall.

Those issues are a far cry from the ones California faced in 1960, when 90 percent of the population was white, the state was flush with cash, and the main challenge was designing a higher-education system that could absorb a tidal wave of new students in the baby boom. The architects of the master plan responded with a promise to provide access to higher education to all high-school graduates who could benefit from it.

continue reading at CHE (password required)

Sharing the Pain: Cutting Faculty Salaries Across the Board

Broad Pay Cuts Make Deep Dents in Morale

By AUDREY WILLIAMS JUNE

Greensboro College has many of the intimate hallmarks of a small, private, liberal-arts college.

Professors give their cellphone numbers to students and routinely provide extra help to those who need it. Classes at the North Carolina institution average 14 people. And one of the students featured on the college Web site is a biology major who plays on the tennis and volleyball teams and says she is grateful that professors are willing to work around her hectic schedule. The college motto is "You belong here!"

But in mid-April, faculty and staff members got some news that cast a pall on the close-knit campus. At a hastily arranged meeting in the chapel where worship services are held every week, President Craven E. Williams announced layoffs and a temporary, across-the-board pay cut of 20 percent for salaried employees. In addition, sabbaticals were shelved and many benefits were cut.

The institution needs $5-million to stay afloat until the fall, when tuition payments roll in. "It's very difficult to tell somebody that you're cutting their pay 20 percent," said Robert Stout, chairman of Greensboro College's Board of Trustees. "But the important thing is to make sure the college survives."

Some colleges, slammed by the nationwide recession, have begun to eliminate specific programs and departments. But those cost savings often take time to materialize. Greensboro and other colleges instead turned to across-the-board measures that could be put in place quickly and have an immediate effect on the bottom line. Pay cuts often fit the bill.

Still, the move has been devastating to the faculty. "People were not expecting that at all," said a faculty member who did not want to be identified by name because, like many of the 75 full-time professors at Greensboro, she now fears for her job. Many are contract employees, there is no faculty senate, and many worry that the administration, which they say blindsided them with the news, is looking for reasons to get rid of more people. In fact, the cuts did not save everyone's job. Seven staff members and one professor were laid off.

"People had already made their sabbatical plans," said the faculty member. "Other people were in tears because they thought they would lose their house. We had no inkling it was this bad."

Sharing Hardship

Other institutions taking the broad-cut approach include Belmont Abbey College, also in North Carolina, where salaries are slated to be cut by 3.5 percent by July 1, the start of the new fiscal year. At the University of North Carolina at Chapel Hill, senior administrators must cut programs, operations, and staffing by 5 percent by the end of this month.

Many who do this say spreading hardship around saves jobs. "Our goal is to keep as many people whole as we possibly can," said Brian Friedrich, president of Concordia University, in Nebraska, which instituted pay cuts, froze hiring, and cut back on adjuncts, among other things, earlier this year. "If that means sharing the pain, we preferred to go that way collectively, as opposed to eliminating this particular area or this group of individuals."

Mr. Friedrich's pay took a 7-percent hit, his leadership team took a 5-percent pay cut, and faculty and professional staff members lost 3 percent of their pay. Beginning July 1, Mr. Friedrich said, his pay cut will increase to 10 percent, and hourly staff members, whose income the college had tried to protect, will end up with a 3-percent cut in pay.

But the "share the pain" approach can harm an institution in the long run, warn some experts. Programs that were once strong are weakened after years of across-the-board cuts. And salary cuts, particularly ones as steep as Greensboro College's, can push people to look elsewhere for work.

In addition, deep pay cuts are not sustainable, said Thomas C. Longin, an independent consultant who specializes in college finances.

"Now you have to think about where you're going to get the money from to build those salaries back up and move forward so you won't lose people," Mr. Longin said. "If you've just dug yourself deeper in the hole, now you have a whole bunch of recovery to do" before you can take advantage of new opportunities.

continue reading (password required)

In Hard Times, Colleges Search for Ways to Trim the Faculty

Why Certain Departments Fall Under the Budget Ax
By ROBIN WILSON

The Jones Theatre at Washington State University is getting a $500,000 face-lift this summer. A construction crew has already ripped out its 500 orange and blue seats and is replacing them with new ones covered in a wine-colored fabric. The theater's walls are being painted a light beige, and a new set of black velour curtains will grace the stage.

But some professors are worried that the theater will remain dark. That's because the department of theater and dance is one of three academic programs slated for elimination because of budget cuts at Washington State. Officials say they must slash a total of $54-million from the university's budget over the next two years. The 11 tenured and tenure-track professors who work in the three programs are also on the chopping block.

Administrators are calling the eliminations "vertical cuts." Instead of slicing costs equally across the board as many other colleges have done, the administration singled out a few that it said were not crucial to the university's mission and attracted few students or little outside research money.

As the economy slumped this year, institutions in other states adopted similar strategies. The Louisiana Board of Regents cut the philosophy major at the University of Louisiana at Lafayette, for instance, and colleges in Idaho, Florida, Michigan, and Wisconsin are also planning to eliminate programs and departments.

That has typically happened after broader austerity measures have failed to stanch enough red ink. "You can bleed to death from a thousand cuts," says Warwick M. Bayly, provost at Washington State. "We felt we had to prioritize."

But selective cuts have their own price. Faculty morale is hurt, and professors worry that the damage extends to the overall reputation of the institution. Terry J. Converse, a professor of theater who has been at Washington State for 18 years, is angry that his department is scheduled to be wiped out completely while others remain largely intact. "It's unconscionable," says Mr. Converse. "It's just not fair to knock off a very functional department that is critical to the liberal arts when it clearly could have been completely avoided."

Justifying the Cuts

As colleges and universities struggle through the nation's economic downturn, most are trying to preserve both academic programs and tenured faculty jobs. When it comes to saving money, universities are laying off staff members, freezing future faculty hiring, imposing furloughs, and trimming operating expenses. Some are merging academic departments, but few are eliminating them outright.

Besides theater and dance, Washington State also wants to get rid of the German major and the department of community and rural sociology. It figures the cuts will save $3.6-million over the next two years. In documents justifying the cuts, officials said professors in theater have too little time for research and that those in community and rural sociology bring in little money for research. Rural sociology has no undergraduate majors, and German awarded only four degrees in 2008. The theater program, administrators said, lacks "visibility and impact."

Other universities that have sliced specific programs include the University of Idaho, which has cut 18 degrees, including master's of arts in the teaching of Spanish, French, German, history, chemistry, and earth science. Administrators at Florida Atlantic University want to suspend the master's program in women's studies. And the political-science major was eliminated this year at Wisconsin Lutheran College after the college laid off the two faculty members who taught in the discipline.

On some campuses, the cuts have become a rallying point for faculty members, students, and alumni. At Louisiana's Lafayette campus, where the philosophy major was cut, a dozen students and alumni boarded a school bus near the campus in late May to attend a Board of Regents meeting in Baton Rouge. They wore white T-shirts with black lettering that said, "Let My People Think." Their mission: to persuade the board to reinstate philosophy. "How can you have a university without a philosophy program?" asks István S.N. Berkeley, an associate professor in the program who traveled to Baton Rouge.

While the regents said they were sympathetic, they did not change their minds. The board had decided in April to cut the philosophy major along with dozens of other "low completer" programs at Louisiana's public colleges. In the last five years, the philosophy program at Lafayette has graduated fewer than four students per year. In documents on the program cuts, the regents said that "philosophy as an essential undergraduate program has lost some credence among students."

continue reading

Financial Regulation and Its Limits

Respinning the web
By John Plender
Published: June 21 2009 19:23 Financial Times

If the financial crisis has taught us anything,” says Michael Taylor, “it is that too much conventional wisdom can be dangerous.” So there is something “slightly unnerving”, adds the former International Monetary Fund economist, about the speed with which a new consensus has emerged on the re-regulation of the financial system – especially when it comes to the concept known in bankerly jargon as “macro-prudential” regulation.

In essence this boils down to the idea that regulation should focus much more on systemic risks instead of assuming that a sound system can be built simply by supervising individual banks. It aims to restrain the kind of build-up of systemic risk that occurred during the credit bubble and which is difficult to address by raising interest rates to damp down asset prices. The chief weapon in the macro-prudential armoury is a capital regime for banks that curbs excessive credit growth.

The effectiveness of macro-prudential regulation is a core assumption behind the capital proposals in last week’s US Treasury white paper on financial regulation. The concept was also roundly endorsed by the de Larosière report to the European Union and in the Turner review in the UK. The underlying philosophy is that if macro-economic analysis had been brought to bear on the design of the financial system, the current debacle might have been either pre-empted or rendered less devastating.

Heavy reliance, then, is being placed on the ability of this new regulatory approach to prevent a future global financial crisis. Yet there is no agreement on how it might work in practice and good reason to question whether it will live up to its advance billing. One very senior former member of the global central banking establishment even says “not only is macro-prudential regulation rubbish, but it gives rubbish a bad name”.

The starting point in the argument is that banking is different. First, because banks borrow short and lend long in the interests of the wider economy but at the cost of putting themselves in a fundamentally risky position: if depositors demand their money back simultaneously, banks cannot pay up because of the mismatch in the maturity of their assets and liabilities. Second, because a loss of confidence in one bank can become contagious across the system. Third, bank failures have externalities, or side effects, that not only inflict losses on other banks but also damage the wider economy – for example, by curbing the supply of credit.

An important role of bank regulation, as the US Treasury white paper underlines, is precisely to address such externalities. It proposes to compel the largest, most interconnected, highly leveraged institutions “to internalize the costs they could impose on society in the event of failure” by imposing tougher capital requirements.

In the run up to the financial crisis the regulatory approach was entirely micro-prudential: it assumed that, if bank supervisors ensured individual banks were safe, systemic stability would look after itself. Yet in a recent report – The Fundamental Principles of Financial Regulation – a group of prominent bankers and academics points out that this view “sounds like a truism, but in practice it represents a fallacy of composition”. This is because, in trying to make themselves safer in a crisis, banks can behave in a way that collectively undermines the system.

It may be prudent, for example, for an individual bank to sell assets when the price of risk increases. Yet if many banks do the same, the asset price will collapse, causing banks to take further steps that can lead to a vicious, self-reinforcing downward spiral in asset prices.

The Turner Review highlights the practical consequences of an unbalanced regulatory approach. In the build-up to the crisis, it says, the Bank of England tended to focus on monetary policy analysis, as required by its inflation target. While the review praises the Bank’s analytical work for its regular Financial Stability Review, it notes that the analysis did not result in policy responses to off-set the risks identified.

For its part, the Financial Services Authority, the UK’s principal regulator, focused too much on the supervision of individual institutions, and insufficiently on wider sectoral and system-wide risks. The review concludes that the vital activity of macro-prudential analysis fell between two stools, leading to what Paul Tucker, deputy governor of the Bank of England, has called “underlap”.

Systemic instability has been further compounded by the pro-cyclicality of regulation, whereby banks are not required to build up enough capital in the good times and are obliged to increase capital in the downturn, so accentuating boom and bust. Much of the damage wrought in the financial crisis was a direct result of Basel I, the global capital regime agreed by the world’s financial regulators. This treated all mortgages as equally risky, so that bankers could take on very high-risk, high-reward subprime mortgage business without having to back it with more capital than that required for safer mortgage business.

Basel II, which started to be implemented last year, addressed this problem by breaking assets down into subcategories and applying risk weights to them. Yet this actually increases pro-cyclicality: as risk grows in the recession, in contrast to Basel I, banks are required to hold more capital just when they are most under pressure. This pro-cyclicality is further exacerbated by mark-to-market accounting, which adds to asset values in the good times and inflicts additional shrinkage when markets turn down.

Bank regulators around the world are already working to reduce the pro-cyclical bias in the system by tinkering with capital adequacy requirements. Yet Lord Turner, chairman of the UK’s FSA, argues that there is a case for going further to introduce overt counter-cyclicality, whereby required and actual capital would rise in good years when loan losses are below long-run averages, creating capital buffers that would be drawn down in bad years as losses increased. He also argues for an overall leverage ratio, looking at assets in relation to capital, as a backstop control measure. Such a ratio also features in the financial regulation plans of the administration of US President Barack Obama.

Capital requirements that track the cycle, together with overall leverage ratios, are thus central planks of the macro-prudential approach. Yet the attempt to counter pro-cyclicality raises huge questions, most notably on the issue of whether regulators should have discretion to change capital requirements in the course of the cycle or whether the capital regime should be subject to pre-determined rules. In a perfect world, giving discretion to regulators to calibrate capital requirements according to the state of the economy makes sense. In the real world, regulators would face the ever-difficult problem of defining where they were in the economic cycle.

Sir Andrew Large, former deputy governor of the Bank of England for financial stability, says the problems of judging how close the system is to a tipping point can be overstated. “I argue that people could put levels of probability on their assessment and then act to calm things down.”

Yet few deny that regulators making such judgments would be subject to huge pressures because, by definition, the purpose is to prevent financial institutions doing what they want to do by making it more expensive or off limits. Charles Goodhart of the London School of Economics, and a former member of the Bank of England monetary policy committee, says regulators and supervisors “will be roundly condemned for tightening regulatory conditions in asset price booms by the combined forces of lenders, borrowers and politicians, the latter tending to regard cyclical bubbles as beneficent trend improvements due to their own improved policies”.

As with monetary policy, it is politically difficult for the guardians of the financial system to take measures that will reduce economic growth in the short term in the interests of fending off a recession no one thinks will happen while the good times still roll.

There lies the case for a rules-based approach. Yet designing a set of rules is no easy task (see box). It would also bring added complexity, not least because big multinational banks operating in different economies would be affected by many different cycles. And there is a risk that inflexible rules could lead to regulatory arbitrage.

Regulatory expert Michael Taylor compares counter-cyclical capital buffers with the “corset”, a form of quantitative control introduced in the UK in 1973 that penalised banks whose deposits grew faster than a pre-set limit. This simply drove money off-shore and the regime had to be scrapped in 1980.

Nor are rules a guarantee against lobbying pressure. The Bank of Spain has been much praised for introducing counter-cyclical provisioning that helped the Spanish banking system to weather the crisis better than most. Yet, as Mr Taylor points out, the Spanish central bank watered down its rules in 2004 because of lobbying by the industry, which argued that the length of the economic expansion had made such rules redundant.

These difficulties with macro-prudential regulation notwithstanding, the direction of travel is clear. Perhaps the most articulate advocate is the FSA’s Lord Turner, who argues in his review for the counter-cyclical regime to be substantially rules based. Yet he wants the best of both worlds, saying that this could be combined with regulatory discretion to add a further layer of requirements if macro-prudential analysis suggested this was appropriate.

The debate on rules versus discretion is set to run and run. There is a risk that more is expected of the macro-prudential approach than it is capable of delivering. This is because financial crises are often precipitated by unprecedented shocks that are inherently difficult to foresee. Yet Sir Andrew Large makes a parallel with the argument for independent central banking 30 or 40 years ago. Most people thought it was too difficult. But it happened, with what he regards as quite creditable results. “We need to have the self-confidence to do the same with systemic stability,” he adds, “for without such a policy we will be condemned to repeat today’s disaster in 10 or 20 years time.”

Fallout and factions: the drama of rewriting the rules

The next 12 months could bring the most dramatic change in financial services regulation in decades, as the US, the UK and the European Union try to tackle the causes of, and fallout from, the global downturn. Plans are moving forward to tighten the rules on everything from hedge funds and over-the-counter derivatives to mortgages and basic bank capital requirements, writes Brooke Masters.

In the US, President Barack Obama has unveiled detailed reform plans. He wants to consolidate several federal banking regulators and give the Federal Reserve new power to regulate systemic risk, supplemented with a council of regulators from other agencies. He also wants to create a consumer financial protection agency to regulate credit cards and mortgages, and require registration for hedge funds and central clearing for many derivatives. Parts of the scheme are already meeting scepticism from Congress, so it is not clear how much will become reality.

The EU is moving in a more piecemeal fashion. The European Commission has put forward an alternative investment directive that would force hedge funds and private equity firms to seek regulatory authorisation, report their strategies and set aside capital against losses. Regulators would also be able to set limits on borrowing. The proposal has drawn sharp criticism from London, where much of the European alternative investment management industry is based, for being restrictive and anticompetitive.

EU leaders are also considering plans to create a pan-European board to monitor systemic risk, as well as a college of supervisors that would provide more consistency among national bank supervisors and resolve disputes among countries. But Gordon Brown, UK prime minister, is fighting plans to make the president of the European Central Bank (to which the UK does not belong) chair of the systemic risk board. London has already secured guarantees that the new supervisory system cannot force any single country to commit taxpayer funds to bail out a troubled bank.

In the UK, the Treasury is due to bring forward its proposal for financial regulation shortly, but splits are opening up. Mervyn King, governor of the Bank of England, wants his institution to be in charge of systemic regulation and has asked for more power to do it. But the Labour government is largely defending the tripartite system it set up more than a decade ago, which divides power among the Bank, the Treasury and the Financial Services Authority.

***

The beauty of the Spanish method

Creating a counter-cyclical capital regime for banks is tough but it has been done, most notably in Spain. Since 2000 banks there have had to make provisions for latent portfolio losses – those likely to occur but which are unrecognised by conventional accounting. This buffer takes the form of a reserve deducted from capital in good times and released in the downturn. It is calculated by comparing long-run credit growth in the economy with the current rate of credit growth. “Dynamic provisioning” offers a better idea of profitability and solvency over time and helps prevent dividend increases in good times that might undermine banks’ solvency. But the Spanish model is not compliant with global accounting standards. And it did not prevent a housing bubble as the macro-prudential approach battled a fierce monetary headwind – the European Central Bank’s one-size- fits-all interest rate was lower than appropriate for a boom economy. Spain’s banking system has nonetheless come through the crisis in better shape than most.

Les cadres se rebiffent

Par DAVID COURPASSON chercheur et professeur de sociologie à EM Lyon.

Michel, manager de haut vol, 38 ans, refuse d’aller fermer un site dans le nord de la France ; 7 directeurs d’agence s’opposent aux nouvelles politiques de marketing de leur banque ; 15 chefs de projet refusent l’arrêt du projet d’un de leurs collègues décidé en haut lieu et s’organisent en blog pour écrire un rapport circonstancié à la direction générale ; 80 commerciaux intentent un procès à leur entreprise pour abus de pouvoir… Isabelle, cadre dans les ressources humaines, ne se rebelle pas, elle aime son boulot. Mais lorsqu’on lui impose des objectifs dont elle ne veut pas, elle s’arrange pour changer de poste. Des faits de cette nature sont fréquents (1), mais on les relève peu car ils sont disséminés.

Le constat que les cadres ne constituent pas un groupe homogène n’est pas nouveau. Le fait qu’ils puissent profiter de leurs ressources de réseau, d’information, d’expertise pour faire bouger les choses est toutefois important dans le paysage social actuel. A ceux qui s’interrogent sur les conséquences possibles de la crise et de l’augmentation de la «rage» sociale en France, ces histoires rappellent qu’entre la radicalisation des comportements, la montée de la violence sociale, l’apathie et le découragement, de nombreux scénarios sont envisageables. Ils vont de la réorganisation complète de certaines carrières, à des prises de parole et autres actes risqués qui sont tournés vers un même objectif : refuser des décisions managériales au nom de valeurs non négociables. Des actions individuelles ou portées par de petits collectifs au sein même des firmes peuvent ainsi compléter les actions organisées par des entités plus institutionnelles comme les syndicats. Si l’engagement des cadres dans la contestation peut paraître bien anodin devant l’ampleur des mouvements de rue impulsés par les syndicats, et si certains s’étonnent de l’intérêt porté à une population qui conserve apparemment un statut privilégié, la question reste intéressante à plusieurs titres.

Le cadre semble en effet bien loin des manifestations : il n’a pas le temps, il est pris entre la proximité avec le «terrain», avec les équipes de travail, et la nécessaire allégeance à une hiérarchie qui l’a promu, qui lui a fait confiance. Le cadre personnifie la loyauté, l’obéissance à la firme. Pourquoi des cadres se retrouvent alors à critiquer ou à refuser les logiques managériales et financières qui s’imposent à eux par ailleurs ? Que peuvent-ils avoir à dire pour justifier leur contestation ? Font-ils autre chose que tenter de préserver un statut menacé ?

Des études conduites auprès des cadres (2) ont permis d’identifier la montée de mouvements de rébellions relativement organisés, qui sont certes locaux et éparpillés, mais qui démontrent la volonté affichée de professionnels de plus en plus nombreux de «dire leur fait» aux responsables des entreprises et de leur montrer que d’autres façons de «gérer le business» existent bel et bien. Ces cadres rebelles s’engagent dans des contestations au sein de leur entreprise, pour en améliorer le fonctionnement, pour identifier les erreurs du management, pour faire en sorte qu’elles ne se répètent pas. Parfois, des cadres démissionnent avec pertes et fracas pour un désaccord de fond sur une décision, sur un principe moral, sur une façon de voir le monde. Dans d’autres cas, leur opposition est plus discrète. Elle se fait à travers un activisme quotidien, une manière bien à eux de servir l’entreprise qui leur permet de faire évoluer les demandes du management.

Quelles que soient les voies suivies par les cadres et la façon dont les entreprises interprètent cette contestation, ce qui compte est la signification sociale de la bascule : lorsque les cadres osent résister et sortir du rôle classique qui leur est dévolu, pour défendre des valeurs et des projets alternatifs, pour défendre des collègues menacés, ou des contrats bafoués, quelque chose se passe dans la société. Quand une population traditionnellement docile se rebelle, c’est qu’une partie essentielle du pacte social qui fonde l’entreprise s’est cassée. Bien sûr, le cadre ne semble pas contester les idéologies capitalistes et financières, il ne cherche pas à renverser les pouvoirs en place. Il semble assumer, encore et toujours, le statut qui a été le sien pendant des décennies. Mais il critique désormais ouvertement le fond et les critères des décisions managériales, en s’appuyant sur sa propre expertise, sa professionnalité, sa connaissance des règles et des ratios mêmes qu’il contribue à appliquer et à étendre dans les firmes.

Le cadre, s’il bascule, aura des arguments majeurs à faire valoir dans le débat social d’aujourd’hui. Il sait mieux que personne pourquoi les entreprises licencient, pourquoi elles délocalisent, pourquoi elles ferment des sites, parce qu’il est souvent la cheville ouvrière de ces décisions prises dans les sièges sociaux des multinationales. Si les cadres basculent dans la contestation, même sans descendre dans la rue, les entreprises seront en danger et devront peut-être, sous la pression d’un mouvement social émergent fondé sur la compétence, reconsidérer certains des fondements mêmes de leur fonctionnement hégémonique. Ce sera la contribution du cadre à la nécessaire transformation du monde capitaliste, et elle sera cruciale.

(1) Voir www.jeresiste.com.

(2) Voir le projet Rebelle : www.oce.em-lyon.com

Auteur, avec Jean-Claude Thoenig, de :Quand les cadres se rebellent (Editions Vuibert 2008).

Cutting question - Consumer Boom?

By Andrew Bounds and Chris Giles

Published: June 16 2009 03:00 Financial Times p 7

As Britain's recession bit over the winter, the country became obsessed with finding someone or something to blame. Greedy bankers, addicted to taking risks and paying themselves lavish sums, took much of the flak, as did hapless financial regulators who failed to react to the danger signs.

But fingers were also pointed at ordinary households: Britons had become hooked on material consumption, fuelled by debt and rising house prices. People flocked to the "Together" range of mortgages from Northern Rock, which offered loans of up to 125 per cent of a property's value until the lender ignominiously failed. London's house prices and luxury shopping boomed on the back of big City bonuses. It was unsustainable and, as economists like to say, things that are unsustainable do not last.

But as Britain starts to enjoy its new sport of spotting the green shoots of economic growth sprout up (and seeing whether they will wither), was it all the standard story of consumer boom followed by inevitable comeuppance? Once you get past the anecdotes, the evidence is against that.

One good place to start is a comparison with the 1980s, when no one doubts Britain's consumers went shopping crazy. As a share of gross domestic product, household consumption rose by almost 2 percentage points, with the big boom between 1985 and 1988, when it reached 60.5 per cent of GDP. In comparison, for all the talk of shop-till-you-drop consumers bashing their credit cards, consumption this decade has fallen as a share of GDP by 1.3 points, with declines even during the supposed consumer boom years of 2006-07.

In this decade, the price of imports, particularly from China, has gone down - so people can feel happier about falling consumption. But this underscores the data findings that households did not go on some dreadful borrowing and spending binge. Based on this and other evidence, economists such as Ben Broadbent of Goldman Sachs become agitated, saying: "I just don't understand why people persist in saying there was a consumption boom - there just wasn't."

But the popular belief, also stoked by many economists and officials, remains that consumption has boomed and that is the prime cause of unsustainability in the economy. The rise in household debt to 160 per cent of disposable income, from 100 per cent in 2000, has to unwind, says Andrew Bridgden of Fathom Financial Consulting, and if that happened gradually, "then growth in consumption would be subdued, perhaps close to zero, for the next 10 years".

The International Monetary Fund last month sang from the same hymn sheet in its annual survey of the British economy. "The high level of household indebtedness constrains the pace of economic recovery," it concluded, at the same time fretting about weaknesses in banks.

Mervyn King, the Bank of England governor, came close to the same interpretation of the feebleness of household finances and the resulting sluggish outlook when presenting the central bank's latest inflation report. "In the light of the state of balance sheets, especially in the financial sector, the [Monetary Policy] Committee judges that the risks are weighted towards a relatively slow and protracted recovery," he said.

The dispute about the fragility of household finances stems from a legitimate fear, underscored by a plunging household savings rate in 2006-07, that households were living well beyond their means. The savings rate even briefly turned negative at the start of 2008, fuelling concerns about overconsumption among households and the inevitable retrenchment to come.

But a closer look shows the main reason for the savings drop appears to be that as inflation rose over that period, so did households' bills and spending. Consumers did not cut other items much, sensing the rise in prices was temporary - which turned out to be the case. Subsequently, incomes rose faster than expenditure, bringing the savings ratio back to 4.8 per cent, a level no different from a decade earlier. Though households could decide to retrench, the evidence that they will is so far rather thin.

But as so often with aggregate data, the real behavioural response of households is difficult to infer from the figures because so many things are going on. This is where microeconomic evidence can help - and this year, evidence has accumulated to suggest that there was indeed no housing-fuelled consumption boom.

John Gathergood and Richard Disney of Nottingham University compared the spending and saving behaviour of the same households over time and found, first, that those renting properties were just as likely to reduce their saving when house prices were booming as home owners were. This result has been seen repeatedly in large-scale economic studies of the UK and is a real challenge to the consumption boom protagonists. Why would renters spend more and save less when house prices rise, since their chances of getting on to the housing ladder had just grown worse?

The two researchers went further and added household expectations of their future incomes to their equations. This they found to be the most important determinant of active decisions to save. Renters, it transpired, saved less alongside homeowners because both groups were optimistic about their future incomes.

Looking at similar data across the Atlantic, the two could also spot a difference between British households, whose upbeat income expectations made them shun saving, and US households, who did respond aggressively to higher house prices.

If there is almost no evidence that consumption boomed this decade in Britain as a result of house price appreciation, why did household debt rise so explosively?

There is no disagreement that high house prices are related to this increase in debt, but a fierce disagreement persists between those who think loose lending criteria forced house prices higher and those who believe, as Mr King does, that high house prices led to higher debt because those buying a home needed a bigger mortgage than the people selling - as the vendors enjoyed capital gains from previous house price rises. While both arguments have merit, the important point is that debt and house prices went together, not debt and consumption.

Then, if consumption is not the obviously unsustainable element, where should the spotlight fall? Government spending on goods and services is the short answer. Health, education, defence and law and order spending (including capital expenditure) grew extremely rapidly from 2000, when all this accounted for 20 per cent of GDP, to the 24.4 per cent it reached in 2008. Although financed by borrowing, this rise appeared under control until the recession hit, because tax revenues were strong, particularly corporation tax paid by the risk-taking financial sector. Again, this was the reverse of the 1980s.

The public spending bonanza, financed by erratic financial sector profits, was clearly unsustainable. With tax revenues slashed by the recession and borrowing set to rise to £175bn ($286bn, €207bn) or 12.5 per cent of GDP, this level of government consumption will not be able to continue. The big story of the next decade will be government retrenchment and deficit reduction.

So what does that mean for the UK economy? As ever in economics, there is good news and bad news. The good news is that the absence of a boom over the past decade implies that a consumer retrenchment is far from a certainty, even with falling house prices. As in the past, incomes - and expectations of income growth - are more likely to determine household consumption than household finances and debt are.

Sterling's 20 per cent fall since November 2007 raises the competitiveness of the UK and should allow net exports and business investment to contribute significantly to growth, replacing government spending. Monetary policy is likely to remain very loose, to encourage demand as the government consolidates the budget. This is a reasonable expectation, says Malcolm Barr of JPMorgan, though it is impossible to know in advance "where is growth coming from".

But the bad news is that the recession has destroyed some of Britain's productive capacity forever - 5 per cent is the Treasury's estimate. Charlie Bean, the Bank of England's deputy governor, adds that the fragility of banks will hit working capital, corporate investment and research and development, so limiting potential growth, while unemployment reduces the skills of many employees.

Moreover, continued household consumption at today's level cannot be taken for granted. Households may find their income growth in the years ahead disappointing, especially as taxes and unemployment rise.

There is also the big unknown global element, which is whether the Asian countries that run big surpluses will put more effort into consuming at home rather than saving abroad. Such a shift would raise global real interest rates and make consumer debt feel more onerous.

Although what is not known outweighs the certainties, the outlook is not as bleak, at least for households, as the simple story of excess followed by penitence. Britain is often a miniversion of the US - but its unsustainable expansion of the past decade was very different.

Do not adjust your data set

One of the problems in determining the degree of any surge in household consumption is that the answer depends on which bit of the national accounts you use.

Gross domestic product - the value of goods and services produced in the economy each year - can be broken down into contributions from household consumption, investment, government spending, and the balance between exports and imports. This decomposition can also be adjusted for the inflation of each component part.

If no inflation adjustment is used, there was no consumer boom this decade. Household consumption fell from 63.5 per cent of GDP at the start of 2000 to 61.4 per cent in the second quarter of 2008, just as the recession began.

But after standardising everything at 2003 prices, the official figures show consumption rising from 61.1 per cent to 62.5 per cent of GDP over the same period.

Over long periods the nominal, or unadjusted, figures are preferable because they are easier to measure and they quantify what households actually spent, not the rather more nebulous concept of what their spending would have been had they bought the same goods and services but at 2003 prices.

Leeds

From mills to tills: an industrial centre turned shopping mecca

Few institutions epitomised the boom and bust of Britain's economic "miracle" more than Leeds United.

The Yorkshire soccer club, whose rugged style won league titles in 1969, 1974 and 1992, transformed itself into a leisure brand listed on the stock market and boasting a team full of young talent. By 2001 it had reached the semi-finals of the European Champions League. Then its debt caught up with it.

Owing £79m, it began a fire sale of players. Peter Ridsdale, chairman, left in 2003 but the shake-up could not stave off bankruptcy - or relegation. "We lived the dream," he said. The nightmare of a third season in the third tier of English soccer continues.

Could the city, which has undergone a similarly stellar transformation, suffer the same fate?

Regenerated after the collapse of the clothing industry in the 1970s, its centre is almost unrecognisable from the days when Montague Burton ran the largest clothing factory in Europe there. With engineering and textiles in decline, Leeds fell back on its other strength: finance. Yorkshire was the home of the building society movement and had a big legal sector. The city rediscovered a taste for shopping evident in the graceful but neglected Victorian arcades. Nothing did more to change its image than the opening of the first branch outside London of Harvey Nichols, the upmarket department store,in 1996.

In a decade from 1991 the number of bars and cafés doubled, with nightclubs and restaurants not far behind, as the leisure economy came to life. Up to £4bn has been ploughed into shops, apartments and offices in a centre once dominated by warehouses and mills.

That may reflect an unsustainable consumer binge, or it may just mark Britain's conversion to continental- style café culture. Since 1999 Leeds, with a population of 750,000, has added 31,600 net new jobs, a rise of almost 10 per cent. Yet a large amount have been in public services, and almost all the rest in finance and business services, which each account for one-quarter of the working population. The council believes it will be 2015 before employment returns to 2007 levels and is reducing its own staff by 450.

Civic leaders believe the financial goose will lay golden eggs again. There is still plenty of untapped wealth around: SG Hambros, the private bank, opened an office in the city only in March.

Howard Kew, chief executive of the Leeds Financial Services Initiative, points to the diversity of the sector, which includes asset management, call centres and retail banking. He also notes a tradition of innovation. First Direct, the first telephone bank, set up there in 1989. The recession could even help, as costs in Leeds are one-third lower than London, he adds.

Martin Allison, dean of Leeds Metropolitan University Business School, accepts the city has "suffered a systemic shock". But, he says, "it has had them before. Thirty years ago we were wondering what would come after textiles".

Andrew Bounds

Credit crunch causes analysts to rethink rational market theory

By Gillian Tett, Capital Markets Editor
Published: June 16 2009 03:00 Financial Times

A new realisation has dawned among the most fervent advocates of financial analysis and collective investor wisdom: markets are not always rational.

For the past five decades, the Chartered Financial Analyst Institute has been teaching the tenets of analysis based on efficient markets to tens of thousands of adherents from banks, fund managers and investment houses that make up the global financial system.

Now, however, the credit crisis has forced high priests of rational market theory to question their own creed.

The British CFA recently asked members for the first time whether they trusted in "market efficiency" - and discovered more than two-thirds of respon-dents no longer believed market prices reflect all available information. More startling, 77 per cent of the group "strongly" or "very strongly" disagreed that investors behaved "rationally" - in apparent defiance of the "wisdom of crowds" idea that has driven investment theory.

The shift is significant as the assumption of efficient markets is a cornerstone of calculating the value of everything from stocks to pension fund liabilities to executive compensation.

William Goodhart, chief executive of the CFA Society of the UK, yesterday admitted the results showed a new mood of "questioning" following the financial crisis.

However, the trend appears to reflect a wider intellectual swing. In the past three decades, the global asset management industry has been dominated by the so-called "efficient markets" hypothesis, which has given birth to ideas such as the capital asset pricing model, that portrays investing as a trade-off between risk and return.

Extremities of recent market swings have sparked interest among politicians and investors in the field of behavioural finance, which asserts that markets do not behave rationally but can be driven by human emotions such as fear.

However, the CFA survey suggests the finance industry is not yet ready to rip up its creed.

California's 'Gold Standard' for Higher Education Falls Upon Hard Times

By JOSH KELLER

San Francisco

Few documents in higher education have enjoyed the influence or longevity of the California Master Plan for Higher Education, the 1960 law that transformed the state's public colleges and served as a blueprint for public systems across the country.

Even today, almost 50 years after it was written, the master plan retains a mythic status in California, where it continues to provide the foundation of public debate about higher education. Californians routinely invoke the plan's promises of minimal fees and universal access as the basis for nearly any argument about the state's colleges.

Oppose tuition increases? Cite the master plan. Decry cuts in state support for student-aid programs? Cite the master plan. Support, or reject, changes in admissions policies at the University of California? Cite the master plan.

But as California grapples with one of the worst financial crises in its history, the master plan faces criticism that it is irrelevant to the needs and means of the state. Many scholars and college leaders argue that the hallowed document that has served the state so well for decades needs to be rewritten.

"There's probably only one thing that's worse than a public policy that fails, and that's a public policy that succeeds and outlives its usefulness," says Patrick M. Callan, president of the National Center for Public Policy and Higher Education, in San Jose, Calif.

By any measure, California's colleges are still some of the most diverse and highest-quality public institutions in the country. But Mr. Callan and others point to indications that the state's higher-education system, once the gold standard for institutions from community colleges to research universities across the country, is having trouble adapting to California's changing needs.

Compared with other states, California's educational capital is declining, a phenomenon that predates the current recession. In 1990, California ranked 17th in the proportion of its residents ages 25 to 34 who hold bachelor's degrees or higher. By 2007 it ranked 25th, well below other big states like New York, Illinois, and Virginia. (See box at end of article.)

In a report often cited by college leaders, the Public Policy Institute of California estimated this year that the state would fall one million college graduates short of its work-force needs by 2025. The nonprofit group's report suggested that the state's inability to move through college enough Hispanic residents, its fastest-growing group, was a key cause of the shortfall.

Those issues are a far cry from the ones California faced in 1960, when 90 percent of the population was white, the state was flush with cash, and the main challenge was designing a higher-education system that could absorb a tidal wave of new students in the baby boom. The architects of the master plan responded with a promise to provide access to higher education to all high-school graduates who could benefit from it.

Today the plan's focus on access at any cost has its downsides, says Jane V. Wellman, executive director of the Delta Project on Postsecondary Education Costs, Productivity, and Accountability. California, she says, does only a mediocre job getting the 2.7 million students who are enrolled in the nation's largest community-college system to graduate or transfer to four-year universities. Only about one-quarter of the state's community-college students who seek a degree succeed in receiving one or transferring to a university within six years, according to estimates by California State University researchers and others.

The master plan "was a good way to distribute resources and enrollment in a state that was increasing capacity and had an almost limitless pot of revenue to support it," Ms. Wellman says. "It doesn't get to the deeper issue of how to increase educational attainment. The challenge now is how do you get more kids prepared for academic success, and how do you get more students who enroll focused on attainment? And California is falling down on both of those."

As a result, she says, "the master plan has slowly become irrelevant."

Budget Pressures

Her arguments have taken on a new urgency during California's protracted budget crisis, which endangers some of the building blocks of the higher-education system. The state faces a $24-billion budget deficit between now and the middle of 2010, and Gov. Arnold Schwarzenegger, a Republican, has said steep cuts in state spending will be the only way to close the gap.

In recent weeks, Governor Schwarzenegger has proposed eliminating the state's need-based student-aid program, Cal Grants, which is among the most generous in the country and has been crucial to the master plan's promises of access. He has also proposed cutting state support for California State University and the University of California by about 20 percent in the 2009-10 budget year, and reducing funds for the state's community colleges by more than $900-million over the next 13 months.

The proposed budget cuts for colleges and universities themselves, which legislators are expected to approve, will probably decrease the number of students enrolled at state institutions on a scale not seen in at least two decades. Community-college officials estimate that the cuts would force them to reduce the system's enrollment by 250,000 students, which is equivalent to the size of California's entire college-student population when the master plan was written.

Jason Spencer, executive director of the Vasconcellos Project, a nonprofit group that advocates civic engagement, says conversations about state financing of higher education seem to happen in a vacuum, without regard to any sort of long-term goals. The master plan's prescriptions — low fees and universal access — are simply ignored when the economy is weak, he says.

"If we're going to move away from universal access, that's fine," Mr. Spencer says, "but let's have that conversation in the light of day. Let's have that conversation in public."

The Vasconcellos Project is one of several groups lining up to use the 50th anniversary of the master plan to encourage a major revision. The organization is named after a retired state lawmaker who had such influence over the state's colleges in the 1970s and 1980s that some college administrators refer to him as "the Godfather of higher ed."

Over the past 30 years, most reviews of the master plan have failed to result in major revisions. In 2002 a panel of college administrators and others issued a set of recommendations, including one that the state should work to raise the number of students who transfer from community colleges to the University of California. Those recommendations failed to make it through the Legislature.

Mr. Spencer says his group seeks to avoid that fate by working more closely with lawmakers, with a focus on setting long-term goals for higher education in the areas of affordability, access, and degree-completion rates. If everything goes well, a legislative committee aligned with the project will open hearings on the master plan in September and issue policy recommendations about possible revisions next spring.

"We believe that we can get all three segments on the same side," Mr. Spencer says, referring to the state's community colleges and two public-university systems. "What's a reasonable fee policy? How do we maximize federal Pell dollars in community colleges? Let's do the long-term planning."

A System of Factions

But getting the state's three public systems of higher education on the same side has often been difficult.

Among the master plan's most enduring features is its clear delineation of each system's scope and student population. Under the guidelines set out in the plan, the University of California must draw from the top one-eighth of the state's high-school graduates, California State University from the top third, and the community colleges from the rest.

That three-tiered structure helps to focus each system's mission, policy experts say. But they warn that competition among the systems makes it difficult for California to tackle issues, like poor transfer rates, that involve thinking about more than one system at a time.

"These systems might as well be in different states," says Mr. Callan, the policy-center president. "They solve their own problems and leave the students to find their way."

In some states, a higher-education coordinating board helps set statewide priorities and negotiates the interests of competing institutions. But California's board, the California Postsecondary Education Commission, has limited legal authority and a revolving leadership, and is widely viewed as lacking significant influence over state policy. State lawmakers are considering a proposal from Governor Schwarzenegger to eliminate the commission entirely and assign its functions to the state's Department of Education.

The lack of central state leadership on higher education works to prevent major change because each system digs in to protect its own interests, says Robert Atwell, a former president of the American Council on Education and of Pitzer College.

"Good public policy in higher ed is more than the sum total of individual institutional interests," Mr. Atwell says. "It certainly includes those interests, but you've got to have somebody who is looking at more than those individual institutional interests, and you really don't have that much more in California."

For instance, one way to increase the number of students who graduate might be to reallocate state support from the University of California to the other two systems, which have much larger student populations and cost the state less to support per student. "Of course," Mr. Atwell says, "the moment you say that, the University of California wants to crush you."

The state's disastrous financial situation may prove to be an even larger near-term impediment to serious discussions about the future of its higher-education system. In recent months, lawmakers have been preoccupied with keeping the state from going bankrupt, not with devising ambitious plans to remake some of the few major state institutions with a generally solid public reputation.

Charles B. Reed, chancellor of the California State University system, agrees that the master plan is simply "not relevant" any longer. He estimates that if the governor's proposed cuts in state support pass, the system will probably need to cut back enrollment by 40,000 students, or about 9 percent, for the 2010-11 academic year, an unprecedented number.

"There is no way to fulfill the master plan with the current financial capacity and structure that California has," Mr. Reed says.

But in the current budget environment, he says, "tinkering with the master plan is not the issue." He says he has not given much thought to how it might be amended. The real issue, he says, "is the courage of Californians to decide whether they're going to pay for higher ed or for prisons."

Ms. Wellman, of the Delta Project, says that until California gets out of its fiscal crisis and restores some ability to make intelligent policy decisions, defining new state priorities around higher education will be difficult.

But even if the master plan were revised, she says, the document carries so much baggage that it might be better to come up with a new name instead. Solutions that made sense 50 years ago, she says, are now getting in the way.

"The last generation's successes," she says, "become the next generation's problems."

It is in Beijing’s interests to lend Geithner a hand

By Martin Wolf
Published: June 9 2009 19:06 Financial Times

Creditor countries are worrying about the safety of their money. That is what links two of the big economic stories of last week: Chancellor Angela Merkel’s attack on the monetary policies pursued by central banks, including her own, the European Central Bank; and the pressure on Tim Geithner, US Treasury secretary, to persuade his hosts in Beijing that their claims on his government are safe. But are they? The answer is: only if the creditor countries facilitate adjustment in the global balance of payments. Debtor countries will either export their way out of this crisis or be driven towards some sort of default. Creditors have to choose which.

Germany and China have much in common: they have the world’s two biggest current account surpluses, at $235bn and $440bn, respectively, in 2008; and both are also powerhouses of manufactured exports. They have, as a result, suffered from the collapse in demand of overindebted purchasers of their exports. So both feel badly done by. Why, they ask themselves, should their virtuous people suffer because their customers have let themselves go so broke?

Germany and China are also very different: Germany is a highly competitive global producer of manufactures. But it is also a regional power that has shared its money with its neighbours since 1999. Its problem is that its surpluses were offset by its neighbours’ largely private excess spending. Now that the borrowers are bankrupt, their countries’ domestic demand is collapsing. This is leading to a huge expansion in fiscal deficits and pressure for easier monetary policies from the ECB. So Ms Merkel is driven towards undermining the independence of Germany’s central bank, in order to protect the still more vital goal of monetary stability.

Germany may be Europe’s pivotal economy. But China is a nascent superpower. Without intending to do so, it has already shaken the world economy. Incorporating this dynamic colossus into the world economy involves huge adjustments. This is already evident in any discussion of a sustained exit from the crisis.

A recent paper from Goldman Sachs – unfortunately, not publicly available – sheds fascinating light on the impact of China’s rise on the world economy.* In particular, it broadens the analysis of the role of the “global imbalances”, on which I (and many others) have written.

The paper points to four salient features of the world economy during this decade: a huge increase in global current account imbalances (with, in particular, the emergence of huge surpluses in emerging economies); a global decline in nominal and real yields on all forms of debt; an increase in global returns on physical capital; and an increase in the “equity risk premium” – the gap between the earnings yield on equities and the real yield on bonds. I would add to this list the strong downward pressure on the dollar prices of many manufactured goods.

The paper argues that the standard “global savings glut” hypothesis helps explain the first two facts. Indeed, it notes that a popular alternative – a too loose monetary policy – fails to explain persistently low long-term real rates. But, it adds, this fails to explain the third and fourth (or my fifth) features.

The paper argues that a massive increase in the effective global labour supply and the extreme risk aversion of the emerging world’s new creditors explains the third and fourth feature. As the paper notes, “the accumulation of net overseas assets has been entirely accounted for by public sector acquisitions ... and has been principally channelled into reserves”. Asian emerging economies – China, above all – have dominated such flows.

The huge capital outflows were the consequence of policy decisions, of which the exchange-rate regime was the most important. The decision to keep the exchange rate down also put a lid on the dollar prices of many manufactures. I would add that the bursting of the stock market bubble in 2000 also increased the perceived riskiness of equities and so increased the attractions of the supposedly safe credit instruments whose burgeoning we saw in the 2000s. The pressure on wages may also have encouraged reliance on borrowing and so helped fuel the credit bubbles of the 2000s.

The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation.

The story is not just history. It bears just as heavily on the world’s escape from the crisis. The dominant feature of today’s economy is that erstwhile private borrowers are, to put it bluntly, bust. To sustain spending, central banks are being driven towards the monetary emissions of which Ms Merkel is suspicious and governments are driven towards massive dis-saving, to offset higher desired private saving.

Today, Germany wants to preserve the value of its money, while China is desperate to preserve the value of its external assets. These are understandable aims. Yet, if this is to happen, debtor countries have to stabilise their economies without another round of profligate private borrowing or an indefinite rise in government debt. Both paths will ultimately lead to defaults, inflation, or both and so to losses for creditors. The only alternative is for debtors to earn their way out. At the level of an entire country that means a big rise in net exports. But if indebted countries are to achieve this aim, in a vigorous world economy, the surplus countries must expand demand strongly, relative to supply.

China’s decision to accumulate roughly $2,000bn in foreign currency reserves was, in my view, a blunder. Now it has a choice. If it wants its claims on the US to be safe, it must facilitate an adjustment in the global balance of payments. If it and other surplus countries wish to run huge surpluses and accumulate vast financial claims, they should expect defaults. They cannot have both safe foreign assets and huge surpluses. They must choose between them. It may seem unfair. But whoever said life is fair?