A mere 5.4% decline in the value of Citigroup's assets would make Citigroup insolvent.

Moral Hazard


John Makin
at AEI

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Rolf Englund IntCom internetional

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The principal/agent problem

Sweden's status as a small, open economy enabled it to undertake the reflationary, sharp, and sudden currency depreciation that helped to return the country to growth.
Sweden was able aggressively to reflate and stimulate demand for its output by allowing its currency to float.
It is important to understand that that option is not available today to the large economies engulfed in a global crisis.
John H. Makin, American Enterprise Institute (Timbros storasyster) March 2, 2009

America's Harder Hard Landing
By John H. Makin
January 2001

Why Do Financial Firms Take Too Much Risk?
The principal/agent problem
- where interests of managers of financial intermediaries diverge from those of their shareholders -
has been clearly illustrated by the widely publicized cases of Merrill Lynch and Citigroup.
John H. Makin, American Enterprise Institute, November 20, 2007

The terms of departure for both CEOs, especially Stan O'Neal's, undercut the charge of management stupidity while reinforcing the notion that both leaders had taken on too much risk for their firms. While investors in Merrill Lynch could check a website that records the scores of serious golfers and learn that Stan O'Neal played twenty rounds of golf between August 12 and September 30, 2007--as the first phase of the credit crisis was raging--they could also observe his $48 million bonus in 2006, which made him the second-highest paid CEO on Wall Street, together with his exit package estimated at $150 million, and conclude that this man was no idiot. He had negotiated a compensation package that paid him a total of more than $50 million in 2006 to take extraordinary risks and then paid him again in 2007 even when those risks resulted in billions of dollars of losses for Merrill Lynch shareholders.

The transition from the principal/agent problem, which concerns too much risk at the firm level, to the broader systemic risk problem of moral hazard and the threat of stagflation facing the Federal Reserve is tied to the underlying cause of the problems dogging the CEOs of financial institutions worldwide.

The fundamental problem for the financial sector is twofold. First, the trillions of dollars of subprime mortgages and higher-rated assets tied to real estate were created on the assumption that U.S. home prices do not fall persistently. They had not, until 2007, dropped on a year-over-year basis since the Great Depression. But now they are falling at a 5 percent annual rate. Second, the drop in home prices looks likely to accelerate--probably to a negative 10 percent year-over-year rate or more--meaning that further write-downs will be required on mortgage-based assets.

More specifically, if government actions allow further delay in accurately valuing level III assets, or if government actions artificially inflate their value, then the excessive risk-taking that led to the large stock of level III assets in the first place is reinforced. Even more broadly, if, in the name of avoiding recession, the Federal Reserve acts to push up prices by sharply increasing liquidity in the economy, its long-standing commitment to inflation control will be compromised, as will the benefits of higher, more stable growth that have accompanied lower inflation since 1982. An inflation-generating response to excessive risk-taking that has resulted in the collapse of a housing bubble will encourage further risk-taking, larger future bubbles, and still higher inflation.

Full text

The public sector subsidises the banks risk-taking.
It does so because banks provide a utility.
What the banks give in return, however, is gung-ho speculation.

Martin Wolf, FT November 27 2007

Don't Count Too Much on Central Banks
John H. Makin, November 1, 2002

The notion that a central bank can mitigate the pain of business cycles and avoid depressions, an article of faith especially during the "Greenspan" era, is both untrue and counterproductive. We should return our thinking about central banks to a basic truth: They can achieve price stability; they cannot and should not fine tune the economy and stock markets.

Read more here

Comment by Rolf Englund:
I have been reading John Makin for some twenty years I guess, and still become more and mor impressed by him.

Hear, hear and read read!

Articles and Short Publications by John H. Makin

Removal of the famous "Greenspan put"
On Monday, June 9, Bernanke gave a pathbreaking speech entitled
"Outstanding Issues in the Analysis of Inflation"

In two sentences, he contributed to a sharp, fifty-basis-point rise in two-year bond yields. Bernanke said:
[T]he latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.
With those two sentences, Bernanke embarked on a path that may lead to whereby the Fed avoids policy measures that could cause systemic risk in financial markets.
John H. Makin, June 26, 2008