I have written a new paper explaining the issues with policy coordination in economies. Let me know your comments.
Archive for January, 2009
Stephen Cecchetti has written a wonderful paper explaining the financial bubbles. He has written the paper from a central banker’s perspective and adds the challenges it poses to the central banks.
He begins by suggesting the theory behind bubbles:
The criticism of the bubble view is based on the efficient markets logic that markets incorporate all available information and this automatically eliminates bubbles. But there are many circumstances under which the argument fails. The dynamic stories that we tell to explain market efficiency are based on the arbitrage. And when arbitrage fails, so does market efficiency. In fact, even if everyone knows that there is a bubble, there is a broad set of realistic circumstances under which arbitrageurs will not eliminate it.
To understand the importance of this line of reasoning, consider a bubble in the aggregate equity market that is certain to burst. Specifically, imagine that the bubble grows at 5 per cent each quarter, and has a 5 per cent probability of bursting each quarter. The existence of the bubble is common knowledge among the well-informed fund managers, but their naïve investors aren’t sure about it. Will the manager of an open-ended fund take a short position to profit from the bubble? The answer is almost surely no.
Infact, he would instead join the herd and make his return till the bubble bursts. And efficient market hypothesis fails (I think Fama/French should rephrase EMH and say markets are efficient over a medium to long term which they indeed are as various crisis point) . The same idea is also given by Marcus Brunnermeier who incidentally is a key member of Bernnake’s Bubble Laboratory.
If you are from any industry you could send your suggestions to Finance Ministry with respect to impact of financial crisis on India. The press release and details are here.
Another update is Dept of Economic Affairs has launched its internship program for the year 2009-10. It is for post-graduate students in disciplines like economics, management and law. The last date for application is 15 February, 2009. It should be an excellent platform to learn something about economic policy in India. The program was launched in December- 2007.
There are 2 reports evaluating progress of US TARP.
Section 202 of that law requires the Office of Management and Budget (OMB) to submit semiannual reports on the costs of the Treasury’s purchases and guarantees of troubled assets. The legislation also requires the Congressional Budget Office (CBO) to prepare an assessment of each of those reports within 45 days of its issuance. That assessment needs to include a discussion of:
The costs of purchases and guarantees of troubled assets,
The information and valuation methods used to calculate those costs, and
The impact on the federal budget deficit and debt.
At time of CBO total funds used were USD 247 billion (excluding Bank of America’s USD 20 bn). CBO estimates the present value of those investments at USD 183 billion. This implies a total subsidy or net cost of USD 64 billion. This USD 64 billion is the cost to taxpayers. This USD 183 bn could easily be lower or higher depending on the actual market and policy reponses. Say if Citi/AIG are no more or recover much better, the value would differ. Also, if US Govt decides to copy UK and swaps preference shares with Ordinay shares, the valuation would change. THE CBO report also has a nice table (Table 1) summarising the total TARP deals.
When OMB report was written out of USD 350, USD 115 was used. It uses two methods to calculated PV. One gives a loss of USD 25.5 bn and other a gain of USD 12.6 bn.
It is still open to markets whether it will be TARP (relief plan) or a TRAP for taxpayers. But yes it is good to see transparency and sticking to reporting as detailed by the Act.
Luigi Zingales offers his advice for Tim Geithner, the new US Treasury head from 20 Jan 2009. Zingales still believes private capital would flow in markets if Treasury gets its act right. He also says nationalisation is not the answer.
1. Krugman advocates nationalisation, restructuring and then reprivatisation
2. Buiter says temporary nationalisation
UK Treasury has announced series of measures to rescue its financial system. The media was full of reports this morning (see Bloomberg; BBC1, BBC2) that a scheme was on the anvil and UK Government has obliged.
There are 3 press releases from UK Treasury:
- Summarising all the old and new schemes
- A seperate statement on UK’s new initiative - Government’s Asset protection scheme.
- A statement on RBS - In this government has swapped the previously infused preference share capital with ordinary share capital so that dividend payout does not happen; no extra capital to be infused.
Under the new schemes, there are quite a few. UK could also follow the US route and use acronyms for its various schemes. Reading through them is a sure shot way to get a headache. Here is a broad summary:
- Credit guarantee scheme (CGS): This guarantees debt of financial institutions. It was announced earlier but CGS was to shutdown on 9 April 2009. This has been extended to 31 Dec 2009.
- Guarantee scheme for asset backed securities (GSABS): A new facility which will provide guarantees to AAA rated (do they matter now??) asset backed securities. This would include ABS backing mortgages, corporate and consumer debt. Subject to approval and would start on April 2009. Why the delay? Is it just a signal?
- Bank of England liquidity facilities (BoELF): A 30 day liquidity facility to close down on 30 Jan 2009. To be replaced by 364 day facility.
- Bank of England asset purchase facility (BoEAPF): Treasury will issue T-Bills and give the monies to BoE. BoE will then use the money to buy toxic assets from the banking system. This is to be a 50 GBP scheme and begins on 2nd Feb. Which assets??The Bank will be authorised by the Treasury to purchase high quality private sector assets, including paper issued under the CGS, corporate bonds, commercial paper, syndicated loans and a limited range of asset backed securities created in viable securitisation structures.Guarantee scheme for asset backed securities and starts in April 2009 and here UK Treasury is allowing BoE to purchase ABS in Feb 2009. So purchases come first and guarantees later! It should be other way round. This is absurd at its best!! And look at all this investment banking US Treasury-Fed style. Why can’t they follow simple structures?? A similar thing was seen in Swiss version of TARP.
- Government’s Asset protection scheme (GAPS): This is the insurance fund which the above pointed media releases pointed.
Under the Scheme, in return for a fee, the Treasury will provide to each participating institution protection against future credit losses on one or more portfolios of defined assets to the extent that credit losses exceed a “first loss” amount to be borne by the institution. It is intended that the Scheme will target those asset classes most affected by current economic conditions.
The Treasury protection will cover the major part but not all of the credit losses which exceed this “first loss” amount. Each participating institution will be required to retain a further residual exposure, which is expected to be in the region of 10 per cent. of the credit losses which exceed the “first loss” amount. This residual exposure will provide an appropriate incentive for participating institutions to endeavour to keep losses to a minimum.
So, the purpose is you lend and in case of losses above the first loss amount, the Government will bail you out by providing for the losses. The eligible assets under the scheme are (they could be in any currency):
- Portfolios of commercial and residential property loans most affected by current economic conditions;
- structured credit assets, including certain asset-backed securities;
- certain other corporate and leveraged loans;
- and any closely related hedges, in each case, held by the participating institution or an affiliate as at 31st December 2008.
This is a huge plan and if done wrongly could lead to huge moral hazards. I mean how do you calculate first loss amounts when the entire markets have frozen? And with guarantees for ABS coming later, this market will not take-off any soon. The statement says further details of the scheme to be out by last week of Feb. So looks like another signalling device to support free- falling of bank share prices in UK.
- The statement also has a note on Northern Rock . It says NR is not planning to cut its mortgage books. This is to provide a boost to mortgage markets. But how else would NR deleverage?
- There is also a statement on Capital regulation which says capital ratios of banks are not being increased as of now.
This was the summary of the various UK measures. One can even understand these schemes from the functional perspective:
Extending the Duration of Loans - BoELF
Increasing Acceptable Collateral - (BoE has extended the list of acceptable program under BoELF)
Extending the Reach of Lending Facilities – GSABS, BoEAPF, GAPS, CGS
Overall, there is a huge US overhang here. It is I-banking at its best. I don’t know whether UK Govt and regulators are increasing their employment numbers. If they are not then I dont know who would run these schemes. If they are, then it looks as if the schemes are being created to employ the laid-off people from the UK’s financial world (which looks like the case for US as well).
I came across this paper by Stephen G. Cecchetti, Alfonso Flores-Lagunes and Stefan Krausewhich says – “Yes, monetary policy has become more efficient compared to 1990s with 1980s. The idea is:
Over the past twenty years, macroeconomic performance has improved in industrialized and developing countries alike. In a broad cross-section of countries inflation volatility has fallen markedly while output variability has either fallen or risen only slightly. This increased stability can be attributed to either: 1) more efficient policy-making by the monetary authority, 2) a reduction in the variability of the aggregate supply shocks, or 3) changes in the structure of the economy. this paper we develop a method for measuring changes in performance, and allocate the source of performance changes to these two factors.
We apply our technique to a cross-section of 24 industrialized and developing countries in order to compare their macroeconomic performance in the 1980s with that in the 1990s. We are able to determine that in 21 of the 24 countries that we study, monetary policy became more efficient in the 1990s.
In 20 of the 21 countries that experienced more stable macroeconomic outcomes, better policy accounted for over 80% of the measured gain. While policy efficiency improved in Finland, it was unable to completely o.set the increased variability of shocks hitting the economy. Only in Austria and Germany did both policy deteriorate and the variability of supply shocks increase.
Finally, we consider some factors that may help in explaining the cross-country differences in macroeconomic and policy outcomes. Our findings, both in the present paper and in previous research, suggest that elements such as central bank credibility and transparency, together with the nature of the financial system, can account for at least some portion of the observed improvements.
In summary, our results suggest that more efficient policy has been the driving force behind improved macroeconomic performance. At the same time it has also contributed,at least in part, to offsetting an increased variability of supply shocks in some countries. Overall, lower variability of the aggregate supply shocks has usually played a minor role.
The paper is highly technical (atleast for me) and could not understand much of it. Anyways, I thought it would be useful for people who wonder whether monetary policy has improved with time and how do we quantify the same? This paper helps build a model to answer this question.
Fed has launched plethora of schemes to get the financial markets working. Despite number of people explaining the crisis (see this for an overview, Also this new research from Minneapolis Fed) these schemes are extremely difficult to remember.
I came across this excellent way via St Louis Fed economist Craig Aubuchon. He classifies the schemes based on functions. There are three broad schemes according to this classification:
The Initial Expansion: Extending the Duration of Loans - Under this we have TAF
The Second Expansion:Increasing Acceptable Collateral- Under this we have PDCF, TSLF and TALF
The Third Expansion: Extending the Reach of Lending Facilities – AMLF, CPFF, MMIFF
Even if we don’t remember the fancy scheme names, it is useful to understand (and hopefully remember) from this perspective.
Minneapolis Fed has a very useful publication called – Region. It is a quarterly publication. The one thing to look forward in this publication is interview of a leading economist. This interview is not like the usual interviews of economic views but is like a literature survey of the covered economists’ main works.
I have not come across a better source where we get to know the main ideas of all prominent economists minus all the maths models etc. I had pointed to Christina Romer and David Romer’s interview. Here is a list of all the previous interviews. You can subscribe the magazine here
The recent edition has an interview of Ken Rogoff, one of the best macroeconomists we have. Rogoff offers plenty of insights on his research and issues to be resolved after this crisis. Rogoff has done path-breaking research in virtually everything under the sun.Each insight is worth seperate posts.
With so much focus on Great Depression these days what comes as surprising is that Great Depression was a global event (read Romer’s excellent paper to understand where and when did it start; it impacted India as well). Bernanke in his speech and paper (also this excellent paper)also explains how the Depression became a global event. Much of the blame is on Gold Standard I don’t know whether economics textbooks have been updated as till 1990s we always associated Great Depression with US.
I came across this paperby Barry Eichengreen and Peter Temin who show how Great Depression became global because of the Gold Standard. They explore it from a political angle and show it was the reverence and sticking to the gold standard which led to the crisis becoming a full scale global depression. They also point to their analysis which looks at different policy scenarios (for instance say if Germany had left Gold Standard earlier) and the economic outcome.
The best part of the paper is - it is quite short and is just about 14 pages. It explains quite a lot in 14 pages.
Baseline Scenario pointed that BoA is in dire straits and would get Fed/Treasury support after Obama swearing on 20 Jan 2009.
However, things have changed too quickly. Bank of America was given a bailout today itself. Fed/Treasury/FDIC have bailed out BoA. The press release says:
Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $118 billion of loans, securities backed by residential and commercial real estate loans, and other such assets, all of which have been marked to current market value. The large majority of these assets were assumed by Bank of America as a result of its acquisition of Merrill Lynch. The assets will remain on Bank of America’s balance sheet. As a fee for this arrangement, Bank of America will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.
In addition, Treasury will invest $20 billion in Bank of America from the Troubled Assets Relief Program in exchange for preferred stock with an 8 percent dividend to the Treasury. Bank of America will comply with enhanced executive compensation restrictions and implement a mortgage loan modification program.
As part of the agreement, Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $306 billion of loans and securities backed by residential and commercial real estate and other such assets, which will remain on Citigroup’s balance sheet. As a fee for this arrangement, Citigroup will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.
In addition, Treasury will invest $20 billion in Citigroup from the Troubled Asset Relief Program in exchange for preferred stock with an 8% dividend to the Treasury. Citigroup will comply with enhanced executive compensation restrictions and implement the FDIC’s mortgage modification program.
It is just replacement of 2 things- Citigroup with Bank of America and $306 billion with $118 billion. Despite huge criticism that Treasury got a worse deal on Citi than Buffet did on Goldman, nothing seems to have changed. Why should both pay similar yields to Treasury on its 2 seperate investments? Shouldn’t those with higher risky assets pay higher yields? It beats me.
What is also shocking is this fixing business in US financial system. First ML goes in trouble and sells it to BoA saying problem is over. Now BoA says it needs support as Merrill assets continue to bleed. Shouldn’t something have been done in the first step itself? Again, what is going on? US economists thrashed South East Asia and Japan for crony capitalism. This is a lot worse. On these lines, next could be Wells Fargo which took over Wachovia in October 2008.
Further FDIC says:
Separately, the FDIC board announced that it will soon propose rule changes to its Temporary Liquidity Guarantee Program to extend the maturity of the guarantee from three to up to 10 years where the debt is supported by collateral and the issuance supports new consumer lending.
I am shocked and amused to read this news from FT Alphaville:
Forget the culture clash that was expected in Bank of America’s acquisition of Merrill Lynch, which was completed at the start of this month. BofA executives are livid about the true depths of the problems at Merrill, which they feel were glossed over last fall in Merrill’s rush to find a saviour. BofA’s discovery last month of the staggeringly weak condition of Merrill’s balance sheet not only threatened to derail the landmark transaction before it closed, but raised hackles at BofA headquarters in North Carolina, where executives are wondering whether they were sold a pup.
Sirs/Ma’ms, Instead of getting angry please explain and resign.
ARRA is American Recovery and Reinvestment Act -2009 under which Obama’s much discussed fiscal stimulus would be provided. It involves $ 275 bn of tax cuts and $ 500 billion of thoughtful government investments in the sector. Right now plan is proposed and Congress would be debating over it.
The bill and summary is prepared by Committee on Appropriations.
I had posted Association of Zoos and Aquariums requested Obama to include reconstruction and building of zoos and aquariums as part of the fiscal stimulus (it had some economics logic and history backing it).
However, while searching for zoos in the Bill one gets:
SEC. 1109. PROHIBITED USES.
None of the funds appropriated or otherwise made available in this Act may be used for any casino or other gambling establishment, aquarium, zoo, golf course, or swimming pool.
It seems they haven’t lobbied enough.
Fed Chairman Bernanke’s recent speechwas very interesting. He talked about number of issues from Fed’s response to crisis, how Fed intervention is different from Bank of Japan intervention (Yellen was the first to point this), how this is not quantitative easing but credit easing and finally the exit strategy after the crisis. (more…)