Archive for December, 2008

Argentina’s off-balance sheet liabilities was a reason for 2001 crisis

December 22, 2008

Argentina’s 2001 crisiswas a whitewash event and struck the economy when least expected it. (Infact, if you do Google search you get all crisis being associated with Argentina - debt, currency, financial etc with each research showing how bad policies were (at hindsight all looks pretty easy) ). I actually remember the severity of the crisis from FIFA World Cup-2001. In 2001, Argentina had number of greats playing (Batistuta, Veron, Ortega etc). I recall all saying they wanted to win the cup to bring some joys to its people who are suffering from severe crisis. That got me noticed and I tried to read on the crisis but was not able to make much out of it.

Anyways, coming to the main point. I came across this excellent speech from Anne O. Krueger of International Monetary Fund.  The issue is a note of reforms in emerging economies and the title says it all – “Meant Well, Tried Little, Failed Much”. :-) I have yet to come across a better way to sum up the problems of emerging economies. Again, in this crisis they look like loosing more than developed economies.

She points to Argentina’s reforms in 1990 and the crisis in 200s:

In the 1980s, the Argentine economy had contracted by about half a per cent a year, while inflation had soared. At its peak in the late 1980s, Argentine inflation exceeded 3,000 per cent—compared with a peak in Latin America as a whole of just under 500%.

The 1991 Convertibility Plan was seen as new dawn: the aim was to deliver high growth and low inflation, based on disciplined macroeconomic policies and market-oriented structural reform. Argentina wanted to escape from past inflationary failures: and it showed every sign, initially, of a readiness to take the difficult steps needed to deliver macroeconomic stability.

Central to the plan was its guarantee of peso convertibility with the dollar at parity. Having a fixed exchange rate system was seen as crucial for building up the anti-inflationary credibility that the government needed. A quasi-currency board was established in order to underpin the system and so reinforce the government’s commitment. As you know, a currency board requires the central bank to back the monetary base with foreign exchange reserves—in other words, it prevents the government, or the central bank, from printing money to finance public deficits. Almost at a stroke this eliminated one of the principal sources of government-induced inflation.

This is what is called as “meant well”. This led to growth and above all low inflation. However, what surfaced is tried little as initial euphoria died and the weaknesses materialised:

Fiscal control was undermined by off-budget expenditures; and it was too weak to prevent growing reliance on private capital flows to finance government borrowing. The estimated structural fiscal position went from rough balance in 1992-93 to a deficit of about 2.75% of GDP in 1998. But there was persistent off-budget spending, mainly as a result of court-ordered compensation payments after the social security reforms of the 1990s, and arrears to suppliers. This raised the government’s average new borrowing requirements to more than 3% of GDP a year over this period. In 1996, for example, when off-budget spending is included, the total deficit was 4% of GDP.

(emphasis is mine)

Further:

These figures show how vulnerable the public finances were to slow growth: because no fiscal cushion had been created when growth performance was strong. The problem was made worse by overoptimistic assessments of the economy’s growth potential. There were more temporary factors at play than were realized at the time. This, of course, meant that the authorities had less room for maneuver on the fiscal front than they believed.

Added to all this was the fact that the pace of structural reforms lost momentum in the mid-90s; indeed, some reforms were reversed. Perhaps the biggest weakness here was the labor market which has tended to be heavily regulated in Argentina. Individual workers have long enjoyed considerable protection, with high barriers to dismissal and the guarantee of generous fringe benefits.

Hmmm. I am sticking my neck out to say this but similar problems lie in India’s fiscal deficit. The difference is our policymakers are realising this problem and are working at it. In his Union Budget speech (2008-09), India’s Finance Minister said:

I acknowledge that significant liabilities of the Government on account of oil, food and fertilizer bonds are currently below the line. This accounting arrangement is consistent with past practice. Nevertheless, our fiscal and revenue deficits are understated to that extent. There is a need to bring these liabilities into our fiscal accounting. As a first step, I have shown these liabilities clearly in ‘Budget at a Glance’.

Moreover, every country differs and our various ratios may be much better than  Argentina in 2000′s.  For instance, our banking system should be much better  placed than Argentina. However, as we have seen in this crisis nothing can be taken for granted.

The high fiscal deficit and its off-balance sheet items has been known for a long-time. And the concerns have come from official government sources. The Prime Minister’s Economic Advisory Panel in its latest outlook raised this as the biggest concern. Shankar Acharya, a  noted senior economist, says despite reforms fiscal deficit continues to be a part of the reform agenda.

As far as off balance sheet items are concerned I tried to estimate, Indian Government’s off-balance sheet liabilities (it was quite a task let me tell you) and its impact on fiscal deficit. Here are the numbers:

 

Fiscal Deficit
(% of GDP)

Fiscal Deficit + off-balance sheet liabilities
(% of GDP)

2005-06

4.1

4.4

2006-07

3.4

4.4

2007-08

3.1

3.5

Source: RBI, Union Budget 2008-09, CSO

 

 

 

 
In 2006-07, the fiscal deficit was almost 1% higher than projected and in other 2 the difference was around 0.4% of GDP.  In 2008-09, it is expected to be much higher and  PM’s advisory committee has also pointed the same. Let us wait for the final estimates in April 2009.

The high fiscal deficit as it is has been a problem. And now we have these  off-balance sheet items. This puts entire investment community into an uncertain zone as they start doubting the fiscal prudence reforms and leads to a much bigger problem later on. It should be a top agenda to set things right.

Assorted Links

December 22, 2008

1. MR on Japanese Fiscal Policy. WSJ Blog points to a paper on fiscal stimulus. Mankiw points zoos are ready to stimulate the economy. Rodrik points to his proposal to stimulate

2. Fin Prof points to how the first USD 350 billion of TARP have been used

3. Frankel points to one chart that explains the crisis

4. Lusardi points Central banks should be the best place for financial advide

5. Rodrik is in Ethiopia

6. WSJ Blog on the auto-bailout plan. CMB has a great post as well

Claudio Borio predicted the crisis too

December 19, 2008

I think we should just trash the idea that this crisis was unprecedented and no one could have predicted the set of events. It is basically that there were a few economists that saw events coming, it is just that they were ignored.  I had written a long article on 3 economists who predicted the crisis/ recession in different ways which I am linking below. However, the list seems to grow as Mark Carney of Bank of Canada points in a speech:

Few forecast these events; although, in an outbreak of retrospective foresight, an increasing number now claim they saw it coming. The reality is that among all the banks, investors, academics and policy-makers, only a handful were able to identify ahead of time the causes and potential scale of the crisis.

(The Handful were -  Bill White, formerly of both the Bank of Canada and the Bank for International Settlements; Harvard University’s Ken Rogoff; Nouriel Roubini of New York University; Wynne Godley of Cambridge; and Bernard Connolly of AIG Financial Products).

I came across this paper by Caludio Borio of BIS:

Since the 1980s, a number of episodes of financial market distress have underscored the importance of the smooth functioning of markets for the stability of the financial system. At the heart of these episodes was a sudden and drastic reduction in market liquidity, characterised by disorderly adjustments in asset prices, a sharp increase in the costs of executing transactions and, in the most acute cases, a “seizing up” of markets.

This essay explores the anatomy of market distress as well as the policy options to address it. It argues that, despite appearances, the genesis and dynamics of market distress resemble quite closely those of banking distress and that, contrary to conventional wisdom, the growth of markets for tradable instruments, and hence the greater scope to sell assets and raise cash, need not have reduced the likelihood of funding (liquidity) crises.

Read the entire paper and it is like deja-vu for you.  This grudge from William White (one of the people who sw things coming) who is Borio’s colleague (discussed in Bernanke’s profile):

Between 2004 and 2007, White and his colleagues continued to warn about the global credit boom, but they were largely ignored in the United States. “In the field of economics, American academics have such a large reputation that they sweep all before them,” White said. “If you add to that the personal reputation of the Maestro”—Greenspan—“it was very difficult for anybody else to come in and say there are problems building.”

Excellent paper.

The three men who predicted US crisis

(more…)

Banks should maintain a leverage ratio

December 19, 2008

Philipp M Hildebrand, Vice-Chairman of the Governing Board of the Swiss National Bank, has given an insightful speech on governing  banks going ahead. He basically advocates the need for bank regulators to impose a leverage ratio which banks should maintain.

Leverage ratio is defined as Capital/Assets. In this crisis, banks (and other firms) having very low capital compared to the assets has led to much of the problem. He adds that this should not replace Basel norms of keeping capital as per risky assets but complementary to Basel norms. He also lists the problems with leverage ratio – off balance sheet items making calculation difficult, pro-cyclicality and profitability of the banks. Though,  he does not specify what that ratio should be, so we still need to work out.

Bank of Japan joins Fed and SNB

December 19, 2008

I  had pointed Swiss and Fed have  moved closer to 0% regime. Japan has always been near zero and has moved closer to zero now. It cut rates by 20 bps to 0.10% in today’s monetary policy meeting.

When will Japan get out of this mess?

Assorted Links

December 19, 2008

1. WSJ Blog points to another gloomy forecast. It also points to the new Fed Governor

2. Nudges points to an American Book in London’s Parliamentary Bookshop

3. Mankiw points to his concerns on fiscal stimulus

4. Fin Prof points is compensation to be blamed? It also points 36 univs have asked to be included in Obama plan

5. CTB points it isn’t about trade credit but falling demand

ECB (and others) can take some lessons from India

December 18, 2008

FT points:

Lucas Papdemos, ECB vice-president, revealed this week that the central bank could set up a central clearing house for interbank lending in a bid to get money flowing again in the system and reduce costs to end borrowers.

The dearth of interbank lending, which is often put down to a lack of trust between banks, has made cuts in the main interest rates by the ECB and other central banks less effective because they are not directly reducing interbank lending rates, which govern the cost of ordinary borrowing.

Money Markets are frozen in many economies and am sure they would be looking to the ECB solution. In that case, ECB (and others) could take some lessons from India. India has set up CCIL:

The Clearing Corporation of India Ltd. (CCIL) was set up in April, 2001 for providing exclusive clearing and settlement for transactions in Money, GSecs and Foreign Exchange. The prime objective has been to improve efficiency in the transaction settlement process, insulate the financial system from shocks emanating from operations related issues, and to undertake other related activities that would help to broaden and deepen the money, debt and forex markets in the country.

OPEC cuts production for the third time since Sep 2008

December 18, 2008

It is just amazing to see the reversal of fortune for OPEC countries. From an all time high oil prices of nearly USD 150 per barrel in July 2008 to currently USD 40-45  per barrel. This is posing severe strains on these economies as they depend heavily on oil revenues. Till July there were pressures on OPEC to increase production to calm rising prices and now they are cutting production to protect falling prices.

On 17 Dec 2008, OPEC cut production for the third time since Sep 2008 by 2.2 million barrels per day. This makes it a total cut of 4.2 mbpd since Sep 2008.

 

Date

Cuts production by million barrels per day

Sept. 10 2008

0.5

Oct. 24 2008

1.5

Dec 17 2008

2.2

Total

4.2

OPEC raises concerns:

Having reviewed the oil market outlook, including overall demand/supply projections for the year 2009, in particular the first and second quarters, the Conference observed that crude volumes entering the market remain well in excess of actual demand: this is clearly demonstrated by the fact that crude stocks in OECD countries are well above their five-year average and are expected to continue to rise.

Moreover, the impact of the grave global economic downturn has led to a destruction of demand, resulting in unprecedented downward pressure being exerted on prices, which have fallen by more than US $90 a barrel since early July 2008. Indeed, the Conference noted that, if unchecked, prices could fall to levels which would place at jeopardy the investments required to guarantee adequate energy supplies in the medium-to-long term.

Like almost all variables in economics and finance, I haven’t managed to understand the movement in oil prices. In a paper on the oil market, I thought it to be a pretty much a high demand – low supply story leading to rise in oil prices. At that time I thought oil prices are here to stay despite recession impacting severely.

Why? Because the increase in demand was coming from emerging economies and mainly from China. Though Chinese economy is expected to slow down severely, I thought existing demand levels should persist or decrease marginally. Even at existing demand levels, the oil prices shouldn’t have fallen so severely as supply-demand gap would have been still there. However, what is being seen is a huge fall and it looks as if people have stopped consuming oil in a large manner.

Looking at these recent developments, it is amazing to see the role expectations play in shaping economic and financial varaibles. We usually focus on expectations from an inflation perspective but not much research is done on how it influences investment, oil prices etc etc. Managing expectation is surely the key.

Assorted Links

December 18, 2008

1. TTR on the Satyam fallout and the promise it offers

2. MR points to a paper on Nazi’s fiscal policy

3. Krugman points to basic ideas to get rid of liquidity traps. He also points to some discussion on great depression

4. WSJ Blog pointstourism worst since 9/11. WSJ Blog points to new research on credit crunch which says

The common assumption that the credit crunch is the result of banks being short of cash to lend is not accurate, the researchers found. Instead, there is a complex mix of lower demand, higher standards and poor credit quality at play in pushing down loan volumes.

5. Macroblog on the employment numbers

6. Mankiw on crisis and increase in government budget

7. Roth points recession at yale

8. CTB on Ukraine’s crisis. CTB points to four stages of policy interventions in the crisis

How to drive economic growth

December 17, 2008

Ricardo Hausmann of Harvard University has given an insightful speech on the subject of growth.

There are two widely-held views on economic growth:  1) it is a natural outcome of getting ‘the basics’ right– international integration, macroeconomic stability, and contract enforcement; and 2) it is hard, requiring a complete set of first, second, and third generation reforms that have little payoff until they are all implemented.  Yet the evidence shows that growth accelerations do not naturally arise from the Washington Consensus basics, nor do they require extensive reform. Instead, accelerations are triggered by a more effective focus on identifying and removing the binding constraints to growth as they arise.  This shifts the focus from creating a laundry list of reforms to using diagnostic signals to identify what particular constraints are holding back growth in a particular country at a particular time.

Want to read Phd theses of some top economists?

December 17, 2008

I knew MIT has put the economics theses of its PHD students online. However, I didn’t spend much time surfing through the website. The website of all theses is here and economics phd these link is here. It provides great search facility across subjects, names and year. I  found Phd theses of some top economists.

Great resource. Simply amazing.

Assorted Links

December 17, 2008

1. The news of the day is Fed cutting rates to a range of 0% to 0.25%. WSJ Blog points to Fed explanation for the range. It pointsto economists’ views. Krugman on the Fed policyto cut rates to 0% to 0.25%  Mankiw points to possible next FOMC meeting press statement  Econbrowser has some comments as well

2. Al Roth points to an interesting paper on bankruptcy

3. PIB points get ready for a L- shaped slump.

4. CTB points Keynes goes to Africa

5. Econbrowser has an excellent post – finding the exit

6. WSJ Blog says Fed Zings and ECB zags

7. IDB points to a microfinance e-library

8. MR points to a new NBER paper which is the best fiscal policy shock?

UK raises “unwelcome fall in inflation” concerns

December 16, 2008

After reading some basic papers on liquidity trap/zero interest rate/deflation from Eggertsson, Krugman and Ueda , I realise how difficult it is to overcome this economic situation. And one is never even sure of a deflationary scenario till it actually hits. So, I would agree to what Bin Smaghi says (be careful with D words) and instead use Bernanke’s words - an unwelcome fall in inflation (see my post here).

Now, the main story. UK CPI for November was at 4.1% , above the target of 2% (with a band of 1% on both sides). This requires BoE Governor to write a letter to UK Chancellor every 3 months. The letter of BoE Governor (Merv King) to Chancellor is here and reply of Chancellor is here. King says:

Nevertheless, taking all of these factors together, it is likely that overall CPI inflation will return to target in the first half of 2009 and then move materially below it later in the year. It is possible that I will not need to write a further open letter to you in three months time. Indeed, given the shortterm outlook for inflation, it is quite possible that I will next need to write to you to explain why inflation has deviated by more than one percentage point below the target during 2009.

 The Chancellor agrees to the same and says in his pre-budget forecasts he expects inflation to fall to 0.8% in Q42009. The Chancellor also summarises the recent policy initiatives taken in UK for real and financial economy.

What made me interested was 0.8% figure. On seeing the last Fed projection for US economy , the expected inflation is for 2009 is 1.3% to 2.0%. So, UK looks really low which is expected as economy in UK is expected to be much weaker. Now, can this low inflation of 0.8% feed into expectations and lead to a persistence in really low inflation and then towards the dreaded “D” word?

Inflationary Expectations work on both sides. High inflation leads to high inflation expectations and higher inflation. Likewise, lower inflation lead to low inflationary expectations and a much lower inflation. Surprisingly, the evil is usually considered to be first but second is a much bigger and persistent evil as Japan tells us. There is tons of research on the upside of inflation expectations but hardly anything on the downside.

Interesting times surely. Reading through the current events is like reading the introductory textbook on economics where one is taught about events in 1929 Depression. I used to always wonder what is the relevance of teaching these concepts in these times. I couldn’t have been more wrong.

How should policymakers signal/communicate in times of fin crisis?

December 16, 2008

(* This is a longish article)

 

The crisis is being analyzed from all possible angles and will take its own time to be resolved. However, one thing which comes across in this crisis is – how should policymakers signal about the financial crisis to financial market participants and the public in general?

 

It has often been seen that markets react differently to a policy response. Infact, whenever policies have been announced to support markets, equity markets have declined and credit spreads have widened. Moreover, we all know that financial crises are here to stay and this is neither the first nor the last financial crisis to impact mother earth. So, if we are discussing on mechanics of financial crisis we should also be discussing how should policymakers signal/communicate to the public in times of crisis.

 

(more…)

Assorted Links

December 16, 2008

1. WSJ Blog points IMF sees position worsening further

2. Fin Prof points to Madoff’s victim list

3. FCB points stocks are on sale

4. CTB has some excellent crisis jokes

5. ASB has a nice article on India’s downturn

6. TTR points Lehman CEO plans to become an advisor

Housing Market continues to increase prices

December 15, 2008

I don’t understand this hue and cry which real estate companies have been making. They show as if skies are falling for them, but refuse to make any changes in their practices and prices. If any company (or a set of companies) is (are) in trouble and are not able to sell their products, the obvious choice is to incentivise prospective customers. However, such things don’t apply to real estate industry. They drove irrational exuberance and want to continue to live by it (see this article on DLF and Unitech practices by Mint and a primer on economics of home buying in mumbai).

I happened to visit the recent property exhibition at Navi Mumbai by Builders Association of Navi Mumbai and was visibly disappointed. The builders continue to increase prices of properties compared to previous exhibition in 2007. Some seemed to have learnt lessons but are passing off cheap discounts as say 10% off, stamp-duty off etc. This is trivial stuff as the real thing- property prices continue to be high. And despite the government notice to sell property on basis of carpet area, one still has to pay 30%-40% as the super built-up area ( see the explanation here

Now, it is demand and supply basics. They could pass-off these higher prices pre-crisis but if they want to sell off now, they have to lower prices. Why? because there is weak demand.

First, home loans are coming at a higher interest rate. Though banks have lowered rates for houses less than 20 lakhs, there are hardly any houses available for that amount in Mumbai (and I would guess the same for other metros)

Second, people don’t have the kind of incomes they had. Most of  this home buying was driven by people in growth sectors- IT, Finance etc and these sectors don;t have the kind of growth.

Three, people can see now the bubble has been burst with real estate companies losing so much value on stock indices. Financial markets are lead indicators of further trouble to come.

Fourth, the easy money phase is over with foreign money and domestic money drying up. Liquidity may be much better now, but people are wary going forward.

And despite all the trouble no decline in prices.  I have been seeing news channels, reading papers etc on housing markets  and all say the same- hardly any change in prices. I was hearing a radio station where someone from the real estate industry himself said the industry has been thriving on excessive profits for past 4-5 years and that phase seems to be over. However, nothing is being seen in change in prices.

I agree this industry employs large number of people and needs support. But you support an industry which is willing to change as per economics of the situation. All this help from RBI and Government is not going to lead to demand as prices are still too high. And once you include practices (there is just too much information asymmetry between a builder and a buyer, see this), you know the buyer is being taken for a ride.

This is actually a great time to reform the industry and its practices. But there seems to be no effort on this front. What one gets instead is bailouts and cries from the industry.

A nice article on hedge funds

December 15, 2008

Donald MacKenzie has written a nice article on hedge fund industry- practices, strategies and problems. Read the Volkswagon case-study:

Situations in which many hedge funds have similar or identical positions are called ‘consensus trades’ or ‘crowded trades’. Every so often these cause sudden, huge movements in prices that have little or no basis in economic fundamentals such as the prospects for the firm, sector or country at issue.

In the last week of October, for example, Volkswagen briefly became the world’s most valuable company by market capitalisation, but not because investors were suddenly struck by how attractive its cars were or by optimism about the prospects of the motor industry. Rather, a consensus trade had gone disastrously wrong. Volkswagen’s ordinary shares had started 2008 half as expensive again as its preference shares, and the difference had soared during the year.

The holders of preference shares can’t take part in shareholder votes, and they receive a fixed rate of interest rather than the fluctuating dividends offered by ordinary shares, but both kinds of share are stakes in the same firm, and it seemed reasonable to conclude that the growing difference between their prices was an anomaly that would correct itself. So a large number of hedge funds – some say as many as a hundred – bought Volkswagen’s preference shares and short sold its ordinary shares. These matched long and short positions meant that the funds were insulated from overall fluctuations in the company’s fortunes: it ‘was meant to be a low-risk trade’, as one London fund manager told the Financial Times.

Unfortunately, Porsche, which already owns 42.6 per cent of Volkswagen’s ordinary shares, had quietly been increasing its stake by buying call options (a call option is a contract that gives you the right to buy an asset at a fixed price). If it turns all those options into Volkswagen shares, Porsche will own 74.1 per cent of them; the government of Lower Saxony owns a further 20.2 per cent that it’s very unlikely to sell. That would leave only 5.7 per cent of Volkswagen’s ordinary shares available to be traded on the market. However, hedge funds and other traders had between them short sold shares equivalent to 12.9 per cent of the total, and in consequence were obliged to buy and return them. They understandably panicked, and the resultant frantic efforts to buy Volkswagen shares caused the price to quadruple.

Literature Survey on managing capital flows

December 15, 2008

Masahiro Kawai and Shinji Takagi of ADB Institute have produced a gem of a paperon capital flows and its management. Though it is a literature survey and is bound to have references, this one is very rich and all in just 15 pages. There is not much to say as far asn analysis goes, so would just paste the abstract for interested readers: 

How to manage capital inflows remains an important policy issue for many emerging market economies. This paper presents a brief survey of the literature on managing capital inflows, with a focus on developing and emerging market economies. The paper, after discussing the economic characteristics of capital inflows, provides an overview of the evolution of thinking on capital account liberalization, the use of capital controls as an instrument of managing capital inflows, and the effectiveness and limitations of conventional macroeconomic and structural instruments. Although the literature is still evolving, it provides little practical guidance on capital account liberalization. For those countries facing a surge in capital inflows, consensus seems to be that, aside from learning to live with an appreciating (and fluctuating) currency, and strengthening the financial system, there is no effective and sustainable policy measure either to reduce the size of inflows or to prevent the adverse consequence of such inflows. Additional work is especially needed to develop tools to identify and quantify the various risks of capital inflows.

Get ready for increased reports on financial frauds now

December 15, 2008

I have been waiting for this type of news to come. With crisis this deep and huge financial flows pre-crisis, financial frauds is something natural to expect. The events of financial fraud have begun to roll now.

Portfolio points 3 cases of frauds have been reported:

First, we witnessed the New York lawyer Marc Dreier being arrested after impersonating another lawyerin what has to be one of the most bizarre and fascinatingfraud cases in recent history. Charged with swindling hedge funds out of hundreds of millions of dollars, Dreier was denied bail on Thursday after prosecutors called him “an enormous risk of flight.”

Then we had Chicago. Oh, Chicago, your corrupt politicians never cease to captivate the country! Governor Rod Blagojevich was chargedwith brazenly soliciting bribes in his quest to fill the Senate seat vacated by President-elect Barack Obama.

And now, we have Bernie Madoff. The president of Bernard L. Madoff Investment Securities, the 70-year-old Wall Street trader was arrested by the F.B.I. and charged with securities fraud late Thursday. The fraud allegedly totaled over $20 billion.

Here is the Dreir story from NYT which is slightly more complex with issuance of fake promissory notes. What was SEC doing?

Madoff was a classic case of ponzy scheme which is reporetd to have swindled about USD 50 billion from investors. For details see NYT , WSJ, Marketwatch. I liked this from portfolio.com:

Mr. Madoff, 70 years old, allegedly told employees he had a couple of hundred million dollars left and wanted to distribute it before turning himself in to authorities, this person said.You read that right. When the boss comes in and says “Take your bonus now before the Feds get it instead,” you know something is amiss. 

What amazes me is that both Madoff and Dreir managed to swindle not just ignorant public (which is expected to be financially literate) but suave hedge fund investors (Madoff in particular) and managers (Dreir in particular).  In Madoff’s case:

Most Ponzischemes collapse relatively quickly, but there is fragmentary evidence that Mr. Madoff’s scheme may have lasted for years or even decades. A Boston whistle-blower has claimed that he tried to alert the S.E.C. to the scheme as early as 1999, and the weekly newspaper Barron’s raised questions about Mr. Madoff’s returns and strategy in 2001, although it did not accuse him of wrongdoing.

Investors may have been duped because Mr. Madoff  sent detailed brokerage statements to investors whose money he managed, sometimes reporting hundreds of individual stock trades per month. Investors who asked for their money back could have it returned within days. And while typical Ponzi schemes promise very high returns, Mr. Madoff’s promised returns were relatively realistic — about 10 percent a year — though they were unrealistically steady.

This reminds of the classic paper by Dean Foster and Peyton Young who show how difficult it is to differentiate between a genuine fund manager and a con one. They also show how easily a con fund manager can show him to be a genuine one. The paper looks at more sophisticated strategies that con managers can use, Madoff shows it is a lot easier.  

Assorted Links

December 15, 2008

1. Krugman analyses the need for European coordination

2. WSJ Blog points ECB trying to start bank lending

3. Mankiw points to a cartoon on financial engineering

4. CTB points trade is falling

5. Econbrowser pointsto a new paper from John Taylor who criticises Fed for the crisis

6. ASB on financial fraud. MR has some points as well

7. JRV on financial limitations

8. ACB points to 2 Krugman secrets


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