I am pretty late on this. There is already a fair bit of criticism on the new Mishkin bubble article (see Eurointelligence, Caroline Baum, TT Ram Mohan etc etc).

He says there are 2 kinds of bubbles. One credit boom bubble and second irrational exuberance bubble. First causes damages and needs to be looked at and second one just ignore it.

The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.

Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.

The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

A bubble is a bubble. Just because it is an irrational exuberance driven bubble doesnt mean it is not dangerous. The costs of the bubbles in 1987 and dotcom may have been less but it was just plain good luck and they burst a little early. Again the current bubble was also driven by the mad exuberance towards search for yield found in housing assets. And then till 2007 it was all seen as manageable and then it all burst. I don’t think we can classify bubbles like this.

However, what is even more bugging is when he says the current rise in asset prices isn’t a bubble:

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture. The Fed decision to retain the language that the funds rate will be kept exceptionally low for an extended period makes sense given the tentativeness of the recovery, the enormous slack in the economy, current low inflation rates and stable inflation expectations. At this critical juncture, the Fed must not take its eye off the ball by focusing on possible asset-price bubbles that are not of the dangerous, credit boom variety.

But weren’t the same conditions seen in 2001 when rates were kept low again for an extended period? And then a disaster followed after 6 years.

The point is one should be weary of a quick rise in prices of any kind of asset market. There is nothing which changes so quickly justifying a big jump in asset prices. One can always cross question Mishkin’s argument that why are asset markets rising so quickly if the economic situation is so bad? I mean one can understand a gradual rise but the way they have been zipping is certainly something to worry about. It looks like again a big bubble especially when we are told there is too much slack in the system etc. With zero interest rates and so much liquidity the chase for higher yield is all the more.

I also keep wondering this. We always talk about economic history and its lessons to fight and mitigate the impact of crisis. So when a crisis starts, we refer to what Japanese did (and didn’t), What the Nordic countries did, what the South east Asian did etc. In this crisis, we have taken large lessons from Great Depression as the crisis became as deep as the 1930s event.

But why do we forget lessons from economic history when the bubble conditions start? Why do we start thinking of the growth situation as different and fancy? Isn’t that part of the economic history lesson as well? It is the more important lesson which we just want to forget.

The policymakers need to talk tough and r’ber eco history not just in times of crisis but in times prior to the crisis as well. There is no point justifying each growth episode as something great and needed. It just doesn’t help. The end result is disastrous for all.

Addendum:

I  have said this before and am repeating it. I have been a big fan and an avid reader of Mishkin’s work. His writing style is top class and explains ideas really clearly and simply. This Blog started in 2007 and initially lots of posts were dedicated to his work and speeches as he was Fed Governor then.

It is just amazing how this crisis has forced rethinking on much of Mishkin work. I had earlier pointed to his Iceland report before the crisis, which said Iceland was ok. His paper presented in 2007 Kansas City Fed conference on housing bubbles has been off the mark as it underestimated the crisis. Then his this piece on bubbles has been much criticised. The good thing is he acknowledges bubbles are dangerous and mon policy needs to look at them. This was not there before the crisis.

I also came across this paper by Mishkin which says Too Big Too Fail is not as much a problem.

This review essay examines whether too-big-to-fail is as serious a problem as Gary Stern and Ron Feldman contend. This essay argues that Stern and Feldman overstate the importance of the too-big-to-fail problem and do not give enough credit to the FDICIA legislation of 1991 for improving bank regulation and supervision. However, this criticism of the Stern and Feldman book does not detract from many of its messages. Even if the too-big-to-fail problem is not as serious as they contend, the policies they outline can make it less likely that a banking crisis will occur even if driven by other factors. 

How times change? This does not mean I wouldn’t read his work. Just that need to ask more questions and not take it as seriously as I used to.

NYT has a superb article on how Bernanke is getting political lessons. Ron Paul, Texas Republican wants to audit the Fed and take control of Fed. Bernanke has been opposing the move in his speeches/testimonies (see this previous post for the debate).

So the article explains how furious the politicians are and are asking Bernanke to explain the Fed moves in this crisis. How do they explain to the public that Fed gace USD 2 trillion to banks that led to the crisis at the first place. All these are politicians issues and Bernanke needs to explain and is finding it difficult. Reminds you of the excellent Blinder piece on the same.

However, this bit doesn’t sound good:

Voters had become suspicious and unnerved by the Fed because of its trillion-dollar efforts to bail out the financial system, Mr. Frank warned. If the Fed really wanted to survive the disgruntlement in both parties, he continued, Mr. Bernanke would have to step back and let him devise a compromise.

Reluctantly, the Fed chairman agreed to reduce his own visibility on the issue and let Mr. Frank take the lead.

It was just one example of how the Fed has been forced to scramble as its power comes under more fire than at any time in decades.

On Tuesday, a new threat opened up: Senator Christopher J. Dodd, chairman of the Senate Banking Committee, declared that the Fed had been an “abysmal failure” at regulation. He introduced a bill that would strip virtually all of its power to regulate banks, including financial institution considered too big to fail.

Read on the article for more details. Lots of senators asking questions on Fed and its role in the crisis.

Now we all take central bank independence as given and understand its role. But how do you explain that too a politician? The moment he learns that the central bank has been created by the government he is going to be all the more perplexed by the independence issue. I mean Treasury/Finance Ministry guys would understand but there are all kinds of other ministries as well. A central bank has mighty powers as well which makes the issue worse.

Bernanke is taking these lessons and I am sure doing well. The other central bankers could join in as well. Knowing monetary economics is surely the most important task, but knowing the political landscape is as important.

In September, SEC created a new division called Risk, Strategy, and Financial Innovation (HT : JRV Blog)

The new division combines the Office of Economic Analysis, the Office of Risk Assessment, and other functions to provide the Commission with sophisticated analysis that integrates economic, financial, and legal disciplines. The division’s responsibilities cover three broad areas: risk and economic analysis; strategic research; and financial innovation.

“This new division will enhance our capabilities and help identify developing risks and trends in the financial markets,” said Chairman Schapiro. “By combining economic, financial, and legal analysis in a single group, this new unit will foster a fresh approach to exchanging ideas and upgrading agency expertise.”

  Interesting stuff. A division to track financial innovation. But much needed as well.

Henry T. C. Hu of Texas Law School agreed to head the division.

Professor Hu said, “I am honored that Chairman Schapiro has asked me to be the director of this new division at this seminal time. The derivatives revolution, the rise of hedge funds and institutional investors, technological change, and other factors have transformed both capital markets and corporate governance. I look forward to working with the Commission and to using an interdisciplinary approach that is informed by law and modern finance and economics, as well as developments in real world products and practices on Wall Street and Main Street.”

Here is his research work. Looks like a nice combination of finance, economics and law,

JRV Blog has more details 0n Hu and more recruitments in the new division

As if Too Big to Fail was not enough to digest, IMF warns of a new risk- Too Complex to Fail. In its new paper, IMF adds the real problem is too complex to fail.

A snapshot of the paper findings is here.

According to the paper, factors that might be considered indicators of a firm’s vulnerability, and its increasing risk to the financial system overall, include:

• Leverage, which is borrowed capital used to increase a firm’s potential returns

• Illiquid assets, which may need to be sold in order for a firm to raise funds

• The complexity of a firm, coupled with the availability of reliable information about a firm’s investments in a particular security or industry

The paper also lays out a framework to identify which firms/markets are risky etc

It sets out the criteria and principles to help countries determine which firms and markets are systemically important. The paper outlined three main principles:

• The size of a financial firm or market, and the volume of financial services it provides

• The extent to which other parts of the financial system can provide the same services in the event of a firm or financial market’s failure

• The linkages between financial institutions, which might create repercussions in the event of a firm’s failure

I have  always felt Too Complex to Fail is as big an issue. In times of crisis, most financial firms become too complex as information about their assets and liabilities becomes opaque. It is important to remember financial services as it is are farly hiogh on information asymmetry. This escalates in times of crisis and makes everything fairly complex to fail.

 Smaghi of ECB explains:

if you buy a financial product you are, by definition, buying risk. If you only want to preserve the nominal value of your savings, you should just hold cash. The return on an investment compensates you for the inherent risk of the asset you acquire. In other words, the value of a financial instrument is uncertain because it is subject to risk. The greater the risk, the greater the return should be.

 The second part of the answer is that it is not always easy to assess risk. Anyone who enters into a transaction should make his or her own assessment. That may vary not only because of the probability of a specific event, such as the default of the counterparty, but also because of the probability of other events, affecting for instance the other assets held in the portfolio of an investor. But, more importantly, the buyer and seller may value the risk of an asset differently because they might have different information about the asset itself, and its characteristics. In particular the seller – by which I mean the originator – of the asset tends to have more information than the buyer. If the former can hide some of the information, in particular about the risk of the asset, he can sell it at a higher price. In other words, the rate of return will not cover the intrinsic risk of the asset.

This is where the difference between financial products and other products is relevant, not only for individuals but also for society. 

Too complex to fail is a far bigger idea which needs to be understood. The smaller firms if complex can pose large problems as well. LTCM was one example.

• What are you thinking?  Robert J. Shiller
• What is behavioral? Nicholas C. Barberis, Ulrike M. Malmendier, Shane Frederick, and Andrew J. Redleaf
• Do you need a nudge? Richard H.Thaler
• What is behavioral? Nicholas C. Barberis, Ulrike M. Malmendier, Shane Frederick, and Andrew J. Redleaf
•  Can behavioral economics improve law? Christine Jolls 
•  Are we good at making choices?  James Choi, M. Keith Chen, and Judith A. Chevalier
• Does money change your thinking?  Kathleen D. Vohs

The first discussion paper on India’s GST is here. I haven’t read it so far, so no comments.

I came to know y’day that first discussion paper on India’s GST is to be released. So have been looking at all possible govt websites- Finance Ministry, Taxation websites, Prime Minister’s Office, Planning Commission etc etc. But could not find it.

After a lot of google searching managed to locate the paper finally. Thanks a ton to etaxindia.org.

Andrew Haldane once again. I have been covering his works in the crisis and all have been excellent reading (here, here and here).

In his recent paper cum speech co-written with Piergiorgio Alessandri he tells you how banks have changed over the years:

Historically, the link between the state and the banking system has been umbilical.
Starting with the first Italian banking houses in the 13th century, banks were financiers of the sovereign. Sovereign need was often greatest following war. The Bank of England was established at the end of the 17th century for just this purpose, financing the war debts of William III. From the earliest times, the relationship between banks and the state was often rocky.  Sovereign default on loans was an everyday hazard for the banks, especially among states vanquished in war. Indeed, through the ages sovereign default has been the single biggest cause of banking collapse.

For the past two centuries, the tables have progressively turned. The state has instead become the last-resort financier of the banks. As with the state, banks’ needs have typically been greatest at times of financial crisis. And like the state, last-resort  financing has not always been repaid in full and on time. The Great Depression marked a regime-shift in state support to the banking system. The credit crisis of the past two years may well mark another.

Further,

Then, the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks. Causality has reversed.

This is quite true. A complete reversal of history.

He then explores the reason why banks have become so risky and highlights the role of time inconsistent policies that have allowed banks to increase leverage, have low capital and seek higher returns to justify the high risks.

Excellent as always.

What about Indian economy?  It is a bit of both. Government still relies on banking system to help subscribe  to former’s borrowing program (via investment in SLR). Banks on the other hand rely on  government to support in times of crisis like this. The Indian government promised to support banking system if anything goes wrong in this crisis. Then large part of banking system is owned by government so the relationship is always going to be there.

Eurointelligence daily edition of 10 Nov 2009 has this interesting titbit:

EU  finance ministers outraged about Greece

FT Deutschland has an article about the sheer sense of outrage felt, and expressed, by EU finance ministers about the situation in Greece, where the new government suddenly revised upwards the deficit projections from 6 to 12%, citing statistical discrepancies. The EU has lost confidence in Greek statistics, and is now demanding, as a first step, the independence of the country’s statistics bureau. The finance ministers have also commissioned a study on the quality of statistics in the country.

Nice to know India has company. And that too a developed economy at that. For a flavor of Indian statistical system, One should read RBI Governor’s speech.

I had posted a while back on India’s goods and service tax. In that post I had pointed to a primer and a speech from Dr Kelkar. In that speech Dr Kelkar had estimated the gains of GST for Indian economy based on similar gains made in Canada.

In his recent speech (not recent actually, given in October 2009) he adds:

The Finance Commission had appointed a Task Force on GST as well as commissioned a study by NCAER to assess its impact on growth in GDP and exports. The preliminary results of the NCAER study indicate that the growth in GDP can be between 2-2.5 per cent with the implementation of a well designed GST. This pioneering study explores the impact of GST on growth through direct cost reduction as well as cost reduction of capital inputs. The increase in exports can be between 10-14 percent. If we use 3 per cent as a discount rate, and lower estimate of the GDP increase of 2 per cent accruing year after year, the net present value of the GST reform exceeds half a trillion dollars.

This is pretty much the amount he had estimated using Canadian estimates as well. The report is still not out. Atleast I couldn’t find it.

He then addresses issues he has discussed in previous speeches as well. Those who did not read earlier speeches can do a quick read.

The economics of  GST is fairly good but politics …well it is another story altogether.

In 2007, when Riksbank Committee awarded the Economics prize to Mechanism Design Theory, I realized there is something like this in economics.

Adam Smith’s classical metaphor of the invisible hand refers to how the market, under ideal conditions, ensures an efficient allocation of scarce resources. But in practice conditions are usually not ideal; for example, competition is not completely free, consumers are not perfectly informed and privately desirable production and consumption may generate social costs and benefits. Furthermore, many transactions do not take place in open markets but within firms, in bargaining between individuals or interest groups and under a host of other institutional arrangements. How well do different such institutions, or allocation mechanisms, perform? What is the optimal mechanism to reach a certain goal, such as social welfare or private profit? Is government regulation called for, and if so, how is it best designed?

And mechanism design helps in understanding these questions.

I came across this paper which analyses Banking using Mechanism Design. It is written by Fabrizio Mattesini, Cyril Monnet and Randall Wright.

The authors study banking using the tools of mechanism design, without a priori assumptions about what banks are, who they are, or what they do. Given preferences, technologies, and certain frictions – including limited commitment and imperfect monitoring – they describe the set of incentive feasible allocations and interpret the outcomes in terms of institutions that resemble banks. The bankers in the authors’ model endogenously accept deposits, and their liabilities help others in making payments. This activity is essential: if it were ruled out the set of feasible allocations would be inferior. The authors discuss how many and which agents play the role of bankers. For example, they show agents who are more connected to the market are better suited for this role since they have more to lose by reneging on obligations. The authors discuss some banking history and compare it with the predictions of their theory. 

I couldn’t understand bulk of the paper as it is highly technical. But usage of mechanism design to study why banks exist sounded useful to me.

The paper says having a third agent take care of deposits makes it more credible that the parties will honor their transactions. This third agent resembles a bank.

An implication is that delegated storage may be useful: If you deposit your output with a third party who has less incentive or ability to liquidate it for strategic reasons, others are more willing to give you credit. Thus, claims on deposits can be used to facilitate transactions, and this resembles banking. This activity can be part of an e¢ cient arrangement even if the third party has an inferior storage technology. Thus, bank liabilities can be useful for payments even if dominated in return. Although other things being equal, it is obviously better if the bank has access to good storage or other investment opportunities.

 We want to ask, however, why the third party is less inclined than you to renege on obligations. In our approach, future rewards and punishments mitigate strategic behavior, but monitoring is imperfect (opportunistic deviations are detected only probabilistically). Agents with a higher likelihood of being monitored have a greater incentive to make good on obligations and, hence, are better suited to take on the responsibility of holding deposits.

 All these are features we assume to be associated  with a bank. The authors however begin ignoring these assumptions about a bank. And arrive at these ideas using mechanism design theory.