Archive for June, 2010

Fixing financial theories….

June 21, 2010

José De Gregorio, Governor Central bank of  Chile ususally has something interesting to say. 

He has been a leading proponent of this idea- Easy  monetary conditions did not lead to crisis. The crisis originated because of financial markets and that is where the problems lie. 

In his recent speech he spaeks on macro models and the need to fix finance theories. 

On macro models he says there is a need to bring models closer to reality and useful for policymakers. Most econs instead make papers and models to meet publish or perish deadline. There is a trade-off :  sophisticated model which are complex vs closer to reality model which are simpler and more apt for policies. This needs to be balanced:

 Macroeconomics has increasingly moved towards models more rigorously specified, with sound micro-foundations, with all general equilibrium interactions, and explicit informational constraints. However, there will always be tensions between rigor, realism and flexibility. There are many tradeoffs.


The costs of these tradeoffs are often subtle. The tendency to base models on ever more rigorous grounds, although a logical trend, has undesired effects. The incentives for younger academics—the very ones who are supposed to push the borders of knowledge, and who must publish or perish—limit their capabilities for innovation. The required rigor ends up necessarily threatening realism. Nobody expects a model to explain all the complexities of the real world, but the problem is that it can overlook elements that are crucial to understanding and preventing economic disasters like the one we faced some years ago. It may be more rewarding from an academic standpoint to write an equilibrium model explaining some particular phenomenon, than trying to formulate a model that properly represents all the distortions of said phenomenon. It is harder and less rewarding for an academic to formulate distortions—of which the real world has plenty—than to use elegant general equilibrium competitive models to explain important stylized facts with a minimum number of new ingredients. Only a handful of academics are able to think rigorously out of the box, and Kouri was one of them.


He explains it is for this simplicity reason IS-LM and Solow’s growth model were used for many years.


He then looks at theory of finance:

Indeed, the current crisis has revealed that models have a limited ability to deal with all the complexities of the real world. Even current state-of-the-art DSGE models, used in many central banks, have been unable to consider in a manageable and explicit way all the intricacies associated with financial markets’ distortions and imperfect arbitrage, let alone the existence of default and credit losses.

This brings me to the theory of finance. If there ever was one discipline that should have anticipated the vulnerabilities that were building up in financial markets, it was finance. Had the origin of the problem been inflationary, then the problem would have been macroeconomics, but the origin was financial The origin of the crisis was closely related to financial innovation and the creation of instruments that should have diversified risks. ……

It is paradoxical that while asset price theories, and their application to the real world, are based on the existence of full arbitrage (consider, for example, the CAPM), corporate finance theories are essentially dominated by information asymmetries and are plagued by frictions from principal-agent problems. This dichotomy will have to be corrected over time to ensure that more realistic models of how financial markets work become available, models which will shed more light on economic policy recommendations.

This is very well put. It summarises in nut shell the problem of theory of finance. …

Were Europe’s curent problems never imagined?

June 21, 2010

Actually the current problems in Europe were well thought of in advance. Just that probability assigned to them was small. (Warning: started small but ahs turned into a long post) 


Assorted Links

June 21, 2010
  • China has released a statement on making its exchange rate flexible. Here are a few discussions
  • Delong and Cowen war of words
  • Krugman gets the global economy prize awarded by Kiel Institute, Germany. He has an interesting conversation with Germans :-)
  • Mike Moffatt of Worthwhile Canada Blog has a superb analysis on Canada’s fiscal austerity program. Krugman had recently argued that Canada gained despite fiscal consolidation because of 2 reasons – loose monetary policy and currency devaluation. Moffaat says yes mon pol was loose but currency did not devalue. Infact currency moves in opposite direction.
  • Hamilton on inflation or deflation in US?

Some good speeches

June 19, 2010

There are plenty of speeches I have read lately. Here they go:


Importance of number 23 in policymaking

June 19, 2010

Mervyn King is back. he has been giving dull and very few speeches since the crisis. His earlier speeches were full of humor and great insights.

In his recent speech he throws a couple of  great lines. UK has revamped its financial regulation structure recently. FSA would be scrapped and Bank of England will have both micro and macro prudential roles. Plus there will be a financial policy committee like monetary policy committee. He reviews all this and says how BoE is well suited to do the role. on FPC he says:

This type of regulatory regime, and its objectives and tools, are largely untried and untested. But that is not a reason for not trying and not testing. The Financial Policy Committee will be a first. Over the next few years we will put in place a framework for financial stability to parallel that for role of a central bank in monetary policy is to take the punch bowl away just as the party gets going, its role in financial stability should be to turn down the music when the dancing gets a little too wild.

An apt answer to Chuck Prince and likes!! Read the speech for more.

Ok now back to the topic. What is this 23? At the beginning of the speech he says:

In previous years I have sometimes set this gathering a quiz question. Tonight I want to reverse the process by providing the answer and asking you for the question. The answer is 23, and later I shall ask you – to what question is 23 the answer?

He answers at the end:

Let me now return to the quiz question I posed earlier – to what question is 23 the answer? Several plausible answers come to mind. First, 23 is the number of players in England’s World Cup squad in South Africa. Second, it is of course 23 years since England last won the Ashes “down under”. But neither of these are the right answer which is that 23 years is the age difference between the Chancellor of the Exchequer and the Governor of the Bank of England. In case there is any doubt, George is the younger.

There is an economic purpose for the age difference:

This age difference is highly desirable because the appropriate incentives are to allocate the responsibility of determining monetary policy to the older generation, which has a real interest in preserving the value of money, and the responsibility for fiscal policy to the younger generation, on whom falls the burden of excessive debt.

If we are tempted to leave a large burden of debt for the next generation to pay back, what better incentive mechanism than to have as Chancellor someone who has a longer life expectancy than any previous Chancellor on record? Given those incentives, Chancellor, I look forward to a harmonious coordination of monetary and fiscal policy.

Very well said. It is so true as well.

Gold Standard Blog adds:

My mind went back to the average age of Indian Finance Ministers over the years. Does that explain why India has been unable to achieve any meaningful and sustainable reduction in the fiscal deficit?


Assorted Links

June 19, 2010
  • TTR provides a prescription for emerging economies’ banks – Grow but don’t try rule the world
  • Gulzar points to a snapshot of global imbalances
  • Krugman pulls the list of countries that grew after cutting fiscal deficits. All grew either because of huge trade surpluses via devaluation or central banks lowered interest rates. Both not possible now esp for Euroarea.
  • Alos read Guilt-edged Bonds by Krugman :-)
  • WSJ Blog points to a paper which says 2009 crisis is by far the worst financial crisis. Also read Donald Kohn Interview
  • Blattman on outcomes of WOrld Bank’s ABCDE conference
  • PSD Blog on the next victim of Random trials hype

UK bids bye to its tripartite system

June 18, 2010

On 16 June 2010, UK Chancellor of the Exchequer, George Osborne said bye to the revered UK tripartite system of financial regulation.


Assorted Links

June 18, 2010

Meeting John Global….a global citizen in 2026…

June 17, 2010
Krzysztof Rybiński, earlier Deputy President of the National Bank of Poland has this fascinating lecture on the topic. 

He talks about John Global, a Pole who becomes a global citizen after 20 years and what his lifestyle would be. As the lecture is given in 2006 he forecasts the lifestyle in 20 years.  


Why do economists and ordinary people differ on the costs of inflation?

June 17, 2010

I thought there is a general agreement in public that costs of inflation are huge. However, empirically this is not the case and economists differ on the costs.

Yi Wen of St Louis Fed writes an exciting note on the same:

Economists have often puzzled over the costs of inflation. Di Tella, MacCulloch, and Oswald (2001) present cross-country survey evidence that people’s happiness or life satisfaction is adversely related to their country’s inflation rate. Also, survey evidence presented by Shiller (1997) shows that people from all walks of life dislike inflation because they almost unanimously think that inflation erodes their standard of living.

Yet standard economic theory predicts that the costs of inflation are small. The argument is that nominal income can adjust for anticipated inflation, leaving people almost as well off as they would have been in the absence of inflation except for the opportunity cost of holding non-interestbearing cash. Hence, economists commonly measure the cost of inflation as the area under the money demand function, which reflects the deadweight loss of holding cash instead of interest-bearing assets.

By this measure, inflation has surprisingly small costs: about 0.1 to 0.8 percent of consumption when the inflation rate is 10 percent per year. The result is robust regardless of whether aggregate data or household data are used to estimate the demand function of money (see, e.g., Attanasio, Guiso, and Jappelli, 2002).

Hmm. And why do they differ? Li points this could be because of two things – one economists don’t measure it properly. Two, people are myopic not to see the benefits of inflation as well.

Wen (2010) argues that the standard economic measure of the costs of inflation does not take into account the insurance (buffer-stock) function of money. Since inflation destroys the value of money and reduces the demand for cash, it exposes people (especially low-income households) to more consumption variability than otherwise. Based on  this concept, Wen finds that the cost of 10 percent annual inflation is equivalent to the loss of 8 to 12 percent of consumption (or income).

Excellent stuff. And why does public not understand the benefits of inflation? The author points public does not understand the causes of inflation. So say inflation is because of government spending on certain programs. The public may not see how government expenditure will help them. So inflation is kind of a tax via which government reduces its debt levels. Economists in turn calculate costs of inflation be comparing this inflation tax with a normal tax that raises revenues. Such analysis reduces the impact of inflation on public. 

Summary is:

Thus, according to the theory of myopic behavior, when trying to understand the costs of inflation, people may miss not only the connection between inflation and increases in nominal income but also the connection between inflation and the benefits gained from government spending programs. So, the reason why people dislike inflation is similar to why they dislike income taxation.

Fantastic really.

Assorted Links

June 17, 2010
  • This one takes the cake. Krugman says he is mild and softspoken comapred to Adam Posen :-)
  • JRV says Indian regulators need to develop expertise in real time tracking of financial markets. He says:

Many observers in India (including some of the exchanges themselves) have been concerned about this transformation, but this is a global phenomenon and it is delusional to deny this reality. Concomitantly, there has been a blurring of the line between exchanges and brokers.

I don’t agree to this line of reasoning. Just because it is becoming a global reality doesn’t mean it is right and has to be accepted. Lot in ecnomics and finance was being accepted because of the same reason – it is global reality. Infact we need to ask more questions as it is becoming a global reality

  • Gulzar summarises the debate on whether there is a need for fiscal austerity right now. As usual Gulzar provides a linkfest.
  • Cowen points to measures NZ took in 1991 to lower deficit. The measures led to higher growth. Krugman responds to the new fancy – examples of how foreign countries grew despite cutting deficits
  • All links in WSJ Blog are a good read
  • Peston says George Osborne gave the most important speech the City has heard since Gordon Brown’s debut in 1997.

Profile of Paul Romer and Charter cities from a historical perspective

June 16, 2010

Sebastian Mallaby has written a wonderful long article on the topic.

He talks about a city called Lübeck which was perhaps the first charter city in the world (I say perhaps as there could be examples in earlier history as well):


Why were Asian Banks not impacted in this crisis?

June 16, 2010

Madhusudan Mohanty and Philip Turner of BIS have written an insightful paper on the topic.


Assorted Links

June 16, 2010
  • Satyan Mishra of Drishtee Development Communications on microfinance
  • Central bank of Chile the latest central bank to raise interest rates. It raises by 50 bps to 1%. So in developed central banks we have Australia, New Zealand, Norway, Canada raising rates. Chile is next in line to become a developed economies. In developing economies I only recall India
  • Gulzar says oil consumption and production has declined sharpest since 1982
  • IMF has released the latest version of  Finance & Development Magazine. IMF Blog covers the release
  • K@W update on Private Equity 
  • Jeff Frankel on Natural Resources curse

What inflation should Fed target?

June 15, 2010

Fed is not an inflation targeting central bank but there are enough papers debating the issue. It was quite a debate before the crisis.

Now, when we talk about inflation targeting we get into macro ideas – how does it work, how it leads to lower inflation, how it makes central bank more independent and transparent etc. The questions don’t look at a major issue- what measure of inflation should be targeted?


The growth report and new structural economics

June 15, 2010

Justin Yifu Lin and Célestin Monga of World Bank write an excellent paper on the topic.

Here is some background before I discuss the paper.


Inflation May 2010 update

June 15, 2010

WPI index increased from 253.7 in April ’10 to 258.1 in May ‘10. This implied inflation for May ’10 at 10.16% (YoY), higher than market expectations of 9.43% (as per several polls).

 Inflation was higher as market participants expected a lower figure for the manufactured products sub-sector (explained below). For March ’10, inflation was revised upwards from 9.9% to 11.04%.  Once again inflation has been revised upwards significantly. 


IIP April 2010 update

June 15, 2010

IIP for April 2010 was at 17.6% (y-o-y). It was much higher than market expectations of 13.8% (as per different newswires). The figure for March was revised upwards from 13.5% to 13.9%.


Assorted Links

June 15, 2010

Deregulation of interest rates in India: History and Basics

June 14, 2010

Deepak Mohanty, ED of RBI gives a superb speech on the topic.



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