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America's financial system

Law and disorder

Financial institutions are vulnerable to investigation, prosecution and litigation from every direction

A STAFFER at a federal agency says he is often asked how many entities investigate and prosecute financial firms in America. The only short answer he can give is: “a lot”. Here's a longer one.

Some entities are obvious: the Securities and Exchange Commission (SEC); the Commodity Futures Trading Commission (CFTC); the Office of the Comptroller of the Currency; the Federal Deposit Insurance Corporation; and the Department of Justice (DoJ). Others are less well known: the Office of Foreign Assets Control and the Financial Crimes Enforcement Network are both part of the Treasury, for example. The Federal Reserve has gained new powers and responsibilities under the Dodd-Frank act; it is also obliged to pour money into the newly created Consumer Financial Protection Bureau. The Federal Housing Finance Agency has filed lawsuits against banks for allegedly selling risky home loans to Fannie Mae and Freddie Mac without proper disclosure.

Other departments with nominally different patches participate in prosecutions, too. The Department of Housing and Urban Development, for example, had a hand in a $25 billion mortgage settlement struck with big banks earlier this year. The Federal Trade Commission is explicitly blocked from regulating banking, but it too has been involved with litigation concerning the servicing of loans. Pensions are regulated by the Department of Labour.

Many of these entities have sub-departments that act independently of each other. One bank in the recent past found itself under investigation by three separate offices of the SEC (there are a dozen). The DoJ often works through its 93 regional offices. Historically, financial wrongdoing was prosecuted out of the Southern District of New York, which this week sued (San Francisco-based) Wells Fargo for allegedly “reckless” lending practices, among other things. But other attorneys have elbowed into this patch, as has headquarters, which has created a unit for financial crimes in Washington, DC. Any of these units can start its own inquiries, as can Congress itself--witness its recent probe of HSBC's involvement in processing illicit Iranian and Mexican payments.

Beyond all these are parallel departments in state governments, each of which has an attorney-general (cynically referred to as “Almost Governors”). Their statewide jurisdiction overlaps with district attorneys, who are elected locally and are in no short supply--62 in New York state, 58 in California, and on and on--as well as with various departments in each state devoted to the regulation of banking, securities and insurance. Standard Chartered's recent $340m settlement over allegations of evading Iranian sanctions, for example, was with the New York Department of Financial Services (DFS).

And behind them, of course, are private armies of lawyers, ready to march wherever there is money. During fiscal year 2011 the SEC collected $414m in fines from large financial institutions in America, according to NERA, an economic consultancy; settlements in class-action lawsuits reached $1.5 billion during the 2011 calendar year.



The upshot is a deluge of paperwork. If banks once did banking, now they practise law. Wells Fargo has lower legal costs than many of its rivals (see chart) but still receives around 300 state, federal and grand-jury subpoenas a week on average. Some are against the bank itself, though many are legal orders pertaining to the suspected crimes of others. The bank gets so many legal orders--5,000 a week in total--that it has two centres that work full-time on processing them, one on the west coast, one on the east. A specific group works on prioritising the bank's response to subpoenas; a weekly call involving 25-30 of the more senior people in the compliance division is designed to iron out problems that arise from all these requests.

Given what went on during the crisis, it is no surprise that there is lots of litigation. But financial institutions can be hit from multiple directions at once. Investigations into allegations of LIBOR rate-fixing, for instance, already involve the CFTC, the DoJ, state attorney-generals from Connecticut, New York, Massachusetts, Florida, North Carolina and Maryland, and at least 30 serious civil litigants. A reported investigation by Eric Schneiderman, New York state's attorney-general, into tax strategies on the part of private-equity funds could easily also fall into the purview of the Internal Revenue Service and the SEC.

A cast list this varied requires co-ordination. There is a history of different government entities working together to prosecute crimes. Some of this co-operation is practical; it also reflects the legal principle of “comity”, a type of reciprocity that results in one legal jurisdiction voluntarily deferring to another. Since the SEC is limited to civil charges, it often refers cases to the DoJ. Investigations into terrorist finance, sanction evasion and money-laundering have traditionally been in the remit of the Manhattan district attorney.

But as the Standard Chartered case showed, when the DFS brought its charges unilaterally and secured a rapid settlement with the bank, co-ordination between agencies is not guaranteed. Indeed, the DFS's success in collecting $340m may sharpen the incentives to “prosecute by press release”, if only because the rewards for being the first to file can be so great.

A settlement with one regulator, moreover, does not mean settlement with them all. In theory, American law discourages double jeopardy--being prosecuted twice for the same crime. But in practice this does not apply to civil cases, or to cases prosecuted in different systems (ie, federal or state)--a distinction often misunderstood, says David Aufhauser, an attorney with Williams and Connolly and a former Treasury official. Standard Chartered is still being investigated by state and federal agencies over its Iranian payments. Many banks involved in the mortgage settlement in February with an array of federal departments and state attorney-generals are still enmeshed in litigation; California's new “Homeowner Bill of Rights” has created the opportunity for more.

Unsettled

When Eliot Spitzer was New York's attorney-general, he justified this prosecutorial marketplace by arguing that it lit a fire underneath dozy regulators. But it is hard to argue that the current set-up serves justice. Since an indictment against a financial institution can lead to a suspension of its licence, and open the door to private litigation, firms often choose to settle when an investigation is launched. According to NERA, in the course of fiscal year 2011 and the first half of fiscal year 2012, the SEC reached 13 settlements of $5m or more with big financial firms. All were announced on the same day the SEC filed its complaint.

A settlement often suits the authorities as well as the banks. Fines are frequently used to fund government budgets; and many a political career has been launched on the back of a high-profile deal, without the need to prove allegations in court.

This cosy alignment of incentives worries some. If an institution has committed an offence, a settlement mitigates the risks of harsher penalties. If it has not done anything wrong, shareholders are paying up to get prosecutors off their backs. Oklahoma's attorney-general, Scott Pruitt, was the only one of his colleagues not to participate in the national mortgage settlement earlier this year. Mr Pruitt said it had nothing to do with genuine fairness or justice, rewarded bad behaviour and reflected an illicit expansion of regulatory power.

The courts themselves have also voiced concern--particularly about how cases are settled through back-room negotiations. “An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous,” wrote Judge Jed Rakoff, in response to a settlement by Citigroup with the SEC.

To cope with the deluge of litigation, banks are falling over themselves to hire ex-regulators, feeding the idea that the law is too chaotic to be understood by anyone outside the system. Financial firms should of course be held to account when they do wrong. But there must be a better way.

On the origin of specie

Theories on where money comes from say something about where the dollar and euro will go

MONEY is perhaps the most basic building-block in economics. It helps states collect taxes to fund public goods. It allows producers to specialise and reap gains from trade. It is clear what it does, but its origins are a mystery. Some argue that money has its roots in the power of the state. Others claim the origin of money is a purely private matter: it would exist even if governments did not. This debate is long-running but it informs some of the most pressing monetary questions of today.

Money fulfils three main functions. First, it must be a medium of exchange, easily traded for goods and services. Second, it must be a store of value, so that it can be saved and used for consumption in the future. Third, it must be a unit of account, a useful measuring-stick. Lots of things can do these jobs. Tea, salt and cattle have all been used as money. In Britain's prisons, inmates currently favour shower-gel capsules or rosary beads.

The use of money stretches back millennia. Electrum, an alloy of gold and silver, was used to make coins in Lydia (now western Turkey) in around 650BC. The first paper money circulated in China in around 1000AD. The Aztecs used cocoa beans as cash until the 12th century. The puzzle is how people agreed what to use.

Karl Menger, an Austrian economist, set out one school of thought as long ago as 1892*. In his version of events, the monetisation of an economy starts when agricultural communities move away from subsistence farming and start to specialise. This brings efficiency gains but means that trade with others becomes necessary. The problem is that operating markets on the basis of barter is a pain: you have to scout around looking for the rare person who wants what you have and has what you want.

Money evolves to reduce barter costs, with some things working better than others. The commodity used as money should not lose value when it is bought and sold. So clothing is a bad money, since no one places the same value on second-hand clothes as new ones. Instead, something that is portable, durable (fruit and vegetables are out) and divisible into smaller pieces is needed. Menger called this property “saleableness”. Spices and shells are highly saleable, explaining their use as money. Government plays no role here. The origin of money is a market-led response to barter costs, in which the best money is that which minimises the costs of trade. Menger's is a good description of how informal monies, such as those used by prisoners, originate.

But the story just doesn't match the facts in most monetary economies, according to a 1998 paper** by Charles Goodhart of the London School of Economics. Take the widespread use of precious metals as money. A Mengerian would say that this happens because metals are durable, divisible and portable: that makes them an ideal medium of exchange. But it is incredibly hard to value raw metals, Mr Goodhart argued, so the cost of using them in trade is high. It is much easier to assess the value of a bag of salt or a cow than a lump of metal. Raw metals fail Menger's own saleableness test.

This problem explains why metal money has circulated not in lumps but as coins, with a regulated amount of metal in each coin. But history shows that minting developed not as a private-sector attempt to minimise the costs of trading, but as a government operation. It was state intervention, not the private market, that made metal specie work as money.

That suggests another theory is needed, in which the state plays a bigger role in the origin of money. Mr Goodhart called this the “Cartalist” theory. The fiscal wing of government has a huge incentive to move its economy away from barter. Once money exists, income and expenditure can be measured. That means they can be taxed. And the public purse gets a second boost from seigniorage, the difference between the value of the coins and the cost of producing them. On this account, governments impose taxes payable only in money, creating a demand for money that means it will be widely accepted as payment for goods. The state forces the economy away from barter for its own fiscal purposes.

Mr Goodhart used monetary history to test these competing theories. He examined the overthrow of Rome and a period in the tenth century when the Japanese government stopped minting coins. If the origin of money were purely private, these shocks should have had no monetary effects. But after Rome's collapse, traders resorted to barter; in Japan they started to use rice instead of coins. There is a clear link between fiscal power and money.

The struggle for life

The evidence suggests that only “informal” monies can spring up purely privately. But informal money can exist on the grandest scale. The dollar's position as the world's reserve currency is not mandated by any government, for example. Its pre-eminence outside America rests on it being the best option for international transactions. Once a competitor currency becomes preferable, firms and other governments will move on. The good news for the dollar is that the Chinese yuan is not yet widely accepted and suffers from higher inflation, reducing its usefulness. But a shift in the world's reserve currency could be swifter than many assume.

The dollar's other competitor, the euro, has deeper problems. Its origins were not private. Nor is it a proper Cartalist money, backed by a nation state. This means it lacks a foundation in the power of either the market or the state. In his paper, written a year before the euro was introduced, Mr Goodhart was prescient, highlighting “an unprecedented divorce between the main monetary and fiscal authorities”. Cartalists, he said “worry whether the divorce may not have some unforeseen side effects”.

The next crisis

Sponging boomers

The economic legacy left by the baby-boomers is leading to a battle between the generations

ANOTHER economic mess looms on the horizon--one with a great wrinkled visage. The struggle to digest the swollen generation of ageing baby-boomers threatens to strangle economic growth. As the nature and scale of the problem become clear, a showdown between the generations may be inevitable.

After the end of the second world war births surged across the rich world. Britain, Germany and Japan all enjoyed a baby boom, although it peaked in different years. America's was most pronounced. By 1964 individuals born after the war accounted for 41% of the total population, forming a generation large enough to exert its own political and economic gravity.

These boomers have lived a charmed life, easily topping previous generations in income earned at every age. The sheer heft of the generation created a demographic dividend: a rise in labour supply, reinforced by a surge in the number of working women. Social change favoured it too. Households became smaller, populated with more earners and fewer children. And boomers enjoyed the distinction of being among the best-educated of American generations at a time when the return on education was soaring.

Yet these gains were one-offs. Retirements will reverse the earlier labour-force surge, and younger generations cannot benefit from more women working. There is room to raise educational levels, but it is harder and less lucrative to improve the lot of disadvantaged students than to establish a university degree as the norm for good ones, as was the case after the war. In short, boomer income growth relied on a number of one-off gains.

Young workers also cannot expect decades of rising asset prices like those that enriched the boomers. Zheng Liu and Mark Spiegel, economists at the Federal Reserve Bank of San Francisco, found in 2011 that movements in the price-earnings ratio of equities closely track changes in the ratio of middle-aged to old workers, meaning that the p/e ratio is likely to fall. Having lived through a spectacular bull market, boomers now sell off assets to finance retirement, putting pressure on equity prices and denying young workers an easy route to wealth. Boomers have weathered the economic crisis reasonably well. Thanks largely to the rapid recovery in stockmarkets, those aged between 53 and 58 saw a net decline in wealth of just 2.8% between 2006 and 2010.

More worrying is that this generation seems to be able to leverage its size into favourable policy. Governments slashed tax rates in the 1980s to revitalise lagging economies, just as boomers approached their prime earning years. The average federal tax rate for a median American household, including income and payroll taxes, dropped from more than 18% in 1981 to just over 11% in 2011. Yet sensible tax reforms left less revenue for the generous benefits boomers have continued to vote themselves, such as a prescription-drug benefit paired with inadequate premiums. Deficits exploded. Erick Eschker, an economist at Humboldt State University, reckons that each American born in 1945 can expect nearly $2.2m in lifetime net transfers from the state--more than any previous cohort.



america's financial system bank

Boomers' sponging may well outstrip that of younger generations as well. A study by the International Monetary Fund in 2011 compared the tax bills of a cohort's members over their lifetime with the value of the benefits that they are forecast to receive. The boomers are leaving a huge bill. Those aged 65 in 2010 may receive $333 billion more in benefits than they pay in taxes (see chart), an obligation 17 times larger than that likely to be left by those aged 25.

Sadly, arithmetic leaves but a few ways out of the mess. Faster growth would help. But the debt left by the boomers adds to the drag of slower labour-force growth. Carmen Reinhart and Kenneth Rogoff, two Harvard economists, estimate that public debt above 90% of GDP can reduce average growth rates by more than 1%. Meanwhile, the boomer era has seen falling levels of public investment in America. Annual spending on infrastructure as a share of GDP dropped from more than 3% in the early 1960s to roughly 1% in 2007.

Austerity is another option, but the consolidation needed would be large. The IMF estimates that fixing America's fiscal imbalance would require a 35% cut in all transfer payments and a 35% rise in all taxes--too big a pill for a creaky political system to swallow. Fiscal imbalances rise with the share of population over 65 and with partisan gridlock, according to other research by Mr Eschker. This is troubling news for America, where the over-65 share of the voting-age population will rise from 17% now to 26% in 2030.

That leaves a third possibility: inflation. Post-war inflation helped shrink America's debt as a share of GDP by 35 percentage points (see article). More inflation might prove salutary for other reasons as well. Mr Rogoff has suggested that a few years of 5% price rises could have helped households reduce their debts faster. Other economists, including two members of the Federal Reserve's policymaking committee, now argue that with interest rates near zero, the Fed should tolerate a higher rate of inflation to speed up recovery.

The generational divide makes this plan a hard sell. Younger workers are typically debtors, who benefit from inflation reducing real interest rates. Older cohorts with large savings dislike it for the same reason. A recent paper by the Federal Reserve Bank of St Louis suggests that as a country ages, its tolerance for inflation falls. Its authors theorise that a central bank could use inflation to achieve some generational redistribution. Yet pressure on the Fed to cease its expansionary actions has been intense, and led by a Republican Party increasingly driven by boomer preferences.

The political power of the boomers is formidable. But sooner or later, it cannot escape the maths.

Mexican banks

From tequila crisis to sunrise

Mexico's once-dodgy banks are now sturdier than many of their foreign owners

MEXICAN banks have historically not been safe places in which to leave money lying around. When they collapsed in 1995, following the devaluation of the peso and the “tequila crisis”, bankers in Europe and America shook their heads in disbelief at the irresponsible lending that had gone on. A $50 billion bail-out was rustled up by tutting friends and neighbours.



How things have changed. As banks in Europe and America scrabble to meet stricter capital requirements, made necessary by the failures of their own exotic lending practices, Mexico is offering some a lifeline. On September 26th Santander, a Spanish bank, plans to list a quarter of its Mexican subsidiary on stock exchanges in Mexico City and New York. It has already listed subsidiaries in Brazil, Chile and Peru, as well as selling its Colombian unit. These sell-offs have helped to increase its core-capital ratio to 10.1%; the Mexican listing, which is set to raise around $4 billion, will add another half a percentage point.

The offering, priced at two times book value, is a better deal than most European or American banks could get for issuing new shares at home. That's because Mexico's banks are very profitable. Santander Mexico gives a return on equity of almost 20% (see chart), about double the rates commonly found in Europe. Bancomer, the Mexican arm of Spain's BBVA, contributes a third of BBVA's worldwide profits. The Mexican subsidiaries of BBVA, Citibank and Santander are all graded as less risky than their parents by Moody's, a ratings agency. BBVA and Canada's Scotiabank might float their own Mexican operations before too long, suspects Bill Rudman of Blackfriars Asset Management.

Mexican banks' smooth negotiation of the financial crisis owes much to a favourable economic environment and to conservatism in their own lending. First, the economy. After spending much of the past decade in Brazil's shadow, Mexico is moving into the limelight. Last year it outpaced its great Latin American rival; this year it is expected to grow nearly twice as fast, at about 4%.

The countries' changing fortunes are partly due to slowing growth in China, a big buyer of Brazilian commodities and bitter rival of Mexican manufacturers. Thanks to higher Chinese wages and the rising cost of shipping across the Pacific, Mexico is increasingly attractive to foreign investors. Although the American market is sluggish, Mexico is taking a bigger bite of it. HSBC reckons that by 2018 Mexico will overtake Canada and China to become America's main source of imports.

Despite bouncy growth in a middle-income country of 115m people, Mexican banks have also been helped by their own caution. Private debt is equal to only about 20% of GDP, one of the lowest ratios in Latin America (Brazil's is above 50%). Only a third of all Mexican firms have access to commercial-bank loans; among small firms, the proportion is lower still. Many businesspeople complain that Mexico's banks have been playing things too safe.

Part of the stinginess is due a strict credit-scoring regime, operated by two private agencies that are owned mainly by the banks themselves. Rather than be graded, customers are classed simply as creditworthy or not. There is no lower limit on the default necessary to trigger a blacklisting, so a missed phone-bill could render someone ineligible for loans. Fines for missed tax-payments can also land people on the blacklist. “So because you were fined 500 pesos ($40) by the tax authorities, you cannot get credit to buy a car, which would contribute 10,000 pesos in VAT,” complains Giulliano Lopresti of Crea Mexico, an organisation that helps small businesses to get off the ground.

The lucky few who do qualify for credit face steep rates. Although the base rate of interest is 4.5%, most credit cards charge upwards of 40%, plus an annual fee. Most deposit accounts offer below-inflation rates of interest. Customer service is patchy. Queues at branches are scores-deep ahead of holiday weekends; Banamex, a big bank, has called your correspondent every day for two years because its call centre is unable to correct wrong numbers.

With five banks controlling about three-quarters of the market, there is more competition than in many other sectors. But with so many potential new customers, the banks do not need to work that hard to turn a profit. Santander is adding more than 100 branches a year to its network. New laws have allowed supermarkets to turn themselves into banks, though uptake was slowed by an outbreak of credit-card defaults in 2009. Lending is rising by 15% per year, about the fastest a country can manage without giving ratings agencies the jitters. By 2020 it will equal 35% of GDP, thinks Nomura, a Japanese bank.

There are obstacles ahead. Banks will have to overcome a culture in which businesses get most of their credit from suppliers, which offer poor value but are seen as easier to deal with. And family firms will have to meet banks' requirements for accounting and corporate governance. At the moment small firms' accounts are often designed to look bad, for tax purposes, rather than good, to secure credit.

If these problems can be solved, the economy will benefit. Five to six consecutive years of loan growth, in tandem with macroeconomic stability, could add half a percentage point to Mexico's annual growth rate, says Agustin Carstens, the central-bank governor. More foreign-bank listings will be good news for Mexico's modest stock exchange, too. At the moment only one of the country's big banks, Banorte, is traded. Santander's flotation “means more options for investors,” says Jorge Lagunas of Interacciones, a trading house. Plenty for Mexico to celebrate, then--just go easy on the tequila.

Olive-oil prices

Drizzle and drought

The soaring cost of dressing a salad

Treasure groves

ANCIENT artefacts unearthed by archaeologists show that olive oil has been an integral part of Mediterranean life for thousands of years. Appetite for the stuff has since spread: supermarket shelves in northern Europe and other rich countries bow under the weight of an array of oils. The Mediterranean, with its baking summers and warm, wet winters, usually provides an ideal climate for olive groves. But a drought in Spain is having a dramatic impact on the market, according to Thomas Mielke of Oil World, a research firm.

Spain is the Saudi Arabia of olive oil, accounting for nearly half of global production. The absence of rain in Spain might reduce total global output by around 20% compared with a year ago, when the world was awash in over 3m tonnes of olive oil.

High levels of production then had pushed prices to a nine-year low. But over the past three months the price of extra virgin olive oil, the best-quality stuff, has risen by over 50%, to about $3,400 a tonne. Stocks left over from last year's bumper harvest are helping to keep price rises in check but prices over $4,000 a tonne are in prospect. And in some respects last year's overproduction is compounding the problem of the drought. Record yields left olive trees weakened by the strain and unable to bear as much fruit this year.

High prices are a welcome boost to other parts of southern Europe. Italy and Greece are the next-largest producers, responsible for another 20% of global output. But the surge in prices may also help some parts of the world not usually associated with olive groves.

Europe's big producers have long since looked beyond home markets, where consumption has peaked. Northern Europe, whose holidaymakers have become accustomed to the flavours of the south, are consuming more olive oil. Germans are drizzling five times more and the British nearly ten times more olive oil over their food than in 1990. America is the world's third-largest market, with demand growing by almost 6% a year for two decades, according to Rabobank.

The bank sniffs an opportunity for California's olive growers. Higher prices for imports, the chance that the EU will cut subsidies and long-running concerns over the quality of imports (“extra virgin” is a loose category) all stand to improve the competitiveness of costlier Californian oil. American olive oil might grab as much as 5% of the domestic market by 2017, says Rabobank. High-quality oil imported from newcomers such as Australia and Chile also stands to gain.

Spanish olive-oil exporters are unconcerned. Australian presses squeeze out just 20,000 tonnes a year and California's merely 7,000 tonnes, compared with 1m tonnes from Spain. Maybe they should fret more. Europe's winemakers, also dominant since antiquity, ignored the early signs of the rise of New World vintners.

America's Loss Is The Currency Market's Gain

October 29 2012| Filed Under » Currencies, Economics, Economy, Forex, Forex Fundamentals, Forex-Beginner

The historic Smithsonian Agreement of 1971 can be credited with the end of fixed exchange rates, the end of the gold standard and a realignment of the par value system with 4.5% trading bands. However, the agreement was disastrous for the United States and mostly benefited European and Japanese economies because of the agreed upon stipulation that the U.S. would devalue its currency. While the Smithsonian Agreement may not draw memorable historic attention, the fact that a nation can willfully sign an agreement to devalue its currency has lasting ramifications for an economy because a devaluation is a guarantor of deflation and enormous budget and trade deficits. The U.S. dollar declined approximately 8% during the years following the agreement, causing the gold price to top out at $800 an ounce by the late 70s because of its deleverage with the dollar and a commodity boom that would also last well into the late 70s. Both are modern day ramifications of a declining dollar. To fully understand the Smithsonian Agreement and its implications, a brief walk through Bretton Woods may help.

Bretton Woods The 1930s saw a laissez faire, free-floating currency market that threatened not only destabilization and economic warfare for smaller nations, but exchange rates that were unfairly discouraging trade and investment. Along came Bretton Woods, in 1944, and stabilized the system through a new monetary order that would peg exchange rates set at a par value with a gold exchange. Government intervention was allowed if 1% of a nation's balance of payments fell into disequilibrium. Convertible currencies were pegged to $35, with the U.S. buying and selling gold to maintain the price. Since the U.S. dollar was the only stable currency, the States managed the system through the International Monetary Fund (IMF) and became its major financier. This led to major outflows of dollars in financing world economies, causing massive deficits in the U.S. The reason for this was because the U.S. owned a majority of official gold reserves in the 1940s. How much could a dollar be worth with massive deficits backed by gold and a world dependent on the United States for its growth? What a predicament. The Smithsonian Solution To fix deficits would limit dollars and increasing deficits would erode dollars, and both instances would be highly detrimental to European and Japanese growth. So, dollar confidence waned causing 1930s-style currency speculation, except for the U.S., whose currency was backed by gold. Adjustments were needed because the U.S. couldn't stop the deficits, while the European and Japanese economies were threatened by massive surpluses. The answer to these problems was the Smithsonian Agreement. Nations again realigned the currency system, agreeing to a devalued dollar, a new par value and trading bands of 4.5%, with 2.25% on the upper and lower side of trading. One year after signing the agreement, Nixon removed the U.S. from the gold standard because of further dollar depreciation and balance of payments erosion. So, the U.S. started interventions through the swap market, and then through Europe, to support its currencies. This was the first time interventions were used after the Smithsonian Agreement breakdown. Almost two years after the Smithsonian Agreement, currencies free floated because the U.S. refused to enforce the agreements, after raising the gold fixed price twice within this two-year period.

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Free Floating Currencies Free floating is a misnomer because trading bands ensured that a nation's exchange rates did not fall outside of the agreed upon range. Nations didn't have gold or an amount of currencies to pledge on their own to the IMF, and the U.S.'s gold and dollar supply had to be implemented to finance the system. This allowed the American dollar to become the world's reserve currency, a permanent financing currency. But the U.S. only had so much gold and dollars, so with post WWII economic growth on the horizon, it was inevitable that Bretton Woods would break down. If not, then the United States would have destroyed its own economy for the sake of growth in Europe and Japan. Bretton Woods and the Smithsonian Agreement were not monetary systems to allow currencies to trade like a fiat currency based on supply and demand through an open market. Instead, Bretton Woods - and later, the Smithsonian Agreement - was a monetary system designed for trade and investment managed by the IMF, but financed by the U.S. As the U.S. pledged its gold and dollars, it was gaining Special Drawing Rights trade credits and using those credits against other nation's currencies to finance trade. In this respect, the U.S. had to fix its currency price so other nations would have a peg to the dollar and get access to credits. For larger growth states, this was perfect, but detrimental for smaller states because they didn't have enough gold or dollars to gain trade credits. So, a currency pricing imbalance existed for many years through economic growth years after WWII. The time for real tradable, market-driven exchange rates for retail traders would still be many years away. What would come later to assist poorer nations lacking access to the world's trading system was trade-weighted dollars to be used for trade. But this would take many more agreements before actual implementation. The IMF The need for the IMF in this equation was substantial. The IMF ensured that the world's central bankers did not dominate the exchange rate market on their own or in conjunction with other nations; it prevented against economic warfare. The par value system allowed trade to equalize through the use of trade credits. This equalization meant basing the price of a currency on its balance of payments. If balance of payments fell into disequilibrium, the IMF allowed a nation's current price to be adjusted up or down.

The Bottom Line While the Smithsonian Agreement was not perfect and actually hurt the U.S. in the short term, it was an instrument needed to further our path toward real market-driven exchange rates.



Not Your Father's State-Run Capitalism

Once upon a time, there were two kinds of businesses. On the one hand, there were public and privately owned companies such as those that existed in Western-style democracies, which had boards of directors and accountability to shareholders, and competed openly in the free market.

On the other hand state-owned enterprises (SOEs) such as those in the Soviet Union and China, which were tightly controlled by government, packed with party apparatchiks, and stifled honest competition by introducing all kinds of inefficiencies into the market.

"There is still a lot of apprehension about state-owned enterprises"

Never mind whether this was ever truly so black and white--Western countries certainly had their share of state-owned businesses back in the 1970s--but what is clear is that times have changed. Liberalization of markets in many former Communist countries has fundamentally changed how companies operate and how government invests in them.

And yet, the business world has been slow to catch up to these changes, says Associate Professor Aldo Musacchio, a member of the Business, Government, and the International Economy Unit at Harvard Business School. No longer can Western companies afford to write off these firms as noncompetitive threats or unworthy partners on the global business stage.

"There is still a lot of apprehension about state-owned enterprises," says Musacchio. "The debate is very polarized. Either you are the United States or you are the Soviet Union, when in reality the world has many shades of gray."

Over the past several decades, thousands of companies have been privatized in both the developed world and emerging markets. While every company in the former Soviet Union was once state-owned, now only several thousand businesses fit that description. China has gone from hundreds of thousands of state-owned businesses down to around 20,000. Meanwhile, developed countries including Australia, Canada, France, Japan, and the UK have each gone from hundreds to dozens of companies that are either completely or partially controlled by government.

More than just the decline in the number of state-owned companies, however, is the way they are structured.

"Some of the largest state-owned enterprises are becoming almost like private corporations," says Musacchio. "They are traded in stock exchanges and have boards of directors, maybe even with external managers. We haven't always understood these changes."

Leviathan in business

In a new working paper, Leviathan in Business: Varieties of State Capitalism and Their Implications for Economic Performance, Musacchio and colleague Sergio G. Lazzarini of the Insper Institute of Education and Research in Sao Paulo, Brazil, attempt to tease out some of the distinctions that exist in SOEs today, and propose under what circumstances they might be advantageous or even desirable in the marketplace.

In their paper--an advance treatment for a more in-depth book on the reinvention of state capitalism due out next year--Musacchio and Lazzarini make the distinction between companies that are majority-owned by government, and those in which the government has a minority position, a situation that has become increasingly more common over the past few decades.

Within the latter category, they further identify many different types of minority stakes, from partially privatized firms, to those with minority investments by state-holding companies, to those receiving favorable loans from state-owned banks

What they found is that while the number of state-owned firms has decreased overall, the number of truly important state-run companies, such as oil and telecom firms, has remained steady. Moreover, while private companies may work well in countries with well-developed capital markets, countries without a robust sector for private investment can actually benefit from state investments, providing certain conditions are met.

"In Western markets that had more thorough privatization programs, the stock markets developed more, and it became less necessary for government to prop up companies financially. In most emerging markets, however, the failure in capital markets persists, so the government is trying to correct that market failure by investing in minority stakes in private companies or lending at subsidized rates to such firms."

At the same time, many Communist and former Communist countries have gone to great lengths to overcome the agency problems that have formerly vexed state-owned enterprises, where directors' private interests diverged from the interest of the firms they managed.

"In the past, managers of SOEs were sometimes selected according to political interests, and there was no transparency," says Musacchio. "You see a more careful selection now, sometimes even based on merit."

In addition, businesses in which the government is a majority shareholder may be more suitable for countries that recognize a "double bottom line" where compelling social interests--such as energy security, economic development, or job creation--are recognized to be just as important as profit. There's a trade-off, however, as it can open the door to minority investors taking a hit, say as when a government-owned company holds down the price of gasoline in order to benefit voters, but depresses profits for the shareholders of the national oil company.

In the case of minority state investment in businesses, the problem isn't so much agency issues within the firm as much as it is public cronyism, with companies jockeying to curry favor with government for preferential investments or loans based on political connections.

"In that case, government investments may lead to better outcomes when you have certain institutions to control cronyism, such as an independent judiciary and rule of law," says Musacchio. "When a government body is investing in companies it should be very independent in how it makes those decisions."

"It's very important for firms to understand these nuances"

Interestingly, in further research in Brazil, Musacchio and Lazzarini found that companies that received direct government investment, as opposed to subsidized loans, tended to have better performance overall, a phenomenon they attribute to increased accountability and oversight.

"A company may ask for a subsidized loan just to lower expenses even it doesn't really need it," Musacchio says, "while it seems like equity investments only come in when a company really needs it, and when a government becomes an equity shareholder, it tends to monitor more."

Private practice

Not to leave out private companies, the researchers posit that they work best when three separate conditions are met: capital markets are well developed; companies recognize a single bottom line (such as profitability or sales); and governments are able to institute effective regulation. That last condition, says Musacchio, is key.

"In emerging markets, it's very hard to regulate," he says. "Big companies are large enough to lobby and capture elected and government officials." While in some minds that description might also include developed Western democracies, Musacchio says there is no comparison. "I don't play that card that often," he says. "Compared to Nigeria, regulation in the United States is amazing."

In all these discussions, Musacchio hopes to make clear that it's not so much a question of whether state investment in business is good or bad; on the contrary, there is much more nuance involved in thinking about state ownership of companies--both in theory and on a practical level for those competing against them around the world.

"It's wrong to think of these state-owned enterprises as the dinosaurs of the past," he says. "It's very important for firms to understand these nuances, because you are not competing against the Soviet companies, you are competing against the champions of Brazil and China and Russia."

In other words, it's not enough anymore to write off these companies as inefficient leviathans stuck in a hand-out mindset. "They have also learned to leverage the power of government," says Musacchio. "But they have also learned the rules of the market."

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