Archive for September 10th, 2008

Time consistency is also a useful way to understand moral hazard

September 10, 2008

Moral Hazard is one of the most discussed topic in the ongoing crisis. Some say the intervention leads to moral hazard, some deny it. This post is about understanding moral hazard in another fashion.

We usually understand moral hazard from the angle of information asymmetry. This was a result of great analysis by Akerlof. Wikipedia explains:

Moral hazard is related to asymmetric information, a situation in which one party in a transaction has more information than another. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Another very useful way to understand moral hazard is from the angle of time consistency models developed by Finn Kydland and Ed Prescott. They got Nobel Prize in 2004 for their work. (Read Mankiw’s superb primer on the topic). I was reading this Nobel Committee primer explaining Kydland-Prescott work and it struck me that this can be modelled to understand moral hazard as well.

Bernanke, Mervyn King etc all had said before the subprime crisis that they would not intervene in financial markets. The outcome of financial decisions of various firms would have to be faced by respective firms. If they had stuck to their words, we would have called these policies as time consistent. Meaning your actions in future (not to intervene) were consistent with the policies made in the past.

However, they had to intervene and this made the policy time inconsistent. The financial markets knew all along the central bankers would be intervening as similar experiences had been seen in the past. The financial markets piled on huge risks knowing central banks and other authorities will have to intervene as health of financial system was important. This is exactly what moral hazard is and time consistent is another way to understand the approach.

The problem is not as much with current intervention but more with this time inconsistent policies with respect to financial sector. As a result, the risks get bigger with profits going to the firms and losses going to the taxpayers. This is leading to other issues like Too Big to Fail where a financial firm is bailed out as it is considered too big to fail.

Time consistency is as important a concept. The best way to follow it is to have some rules. That is why we have inflation targeting and even our FRBM act is a fine example of the idea. The problem is making rules to limit moral hazard in financial sector. How can we do it?

Rogoff on financial sector excesses

September 10, 2008

I came across this article by Ken Rogoff where he also talks about the growing excesses of financial sector and the need to prune it down. (Thanks to Naked Capitalism for the pointer). I had earlier pointed to Solow’s and various other views as well.

The idea that the world’s largest economies are merely facing a short-term panic looks increasingly strained. Instead, it is becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning. Weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigour.

If this is the right diagnosis of the “financial crisis”, then efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Not allowing the necessary consolidation is weakening credit markets, not strengthening them.

After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions’ key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit.

It is time to take stock of the crisis and recognise that the financial industry is undergoing fundamental shifts, and is not simply the victim of speculative panic against housing loans. Certainly better regulation is part of the answer over the longer run, but it is no panacea. Today’s financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future. 

Rogoff’s words matter as he has done loads of research on financial crises He is a leading economist on issues related to macroeconomics and financial markets. He would most likely be disappointed as authorites are busy with one intervention after the other leading one bail-out to another.

Despite Singur West Bengal remains upbeat

September 10, 2008

News about a country/state usually leads to changes in the yields in the Bonds of the respective country/state. The impact of bad news on the bond markets differ. Bad news like higher than expected fiscal deficits, high inflation, poorer investment climate, rating agencies downgrade etc should lead to lower prices (yields hardening). Other bad news like lower GDP, higher unemployment leads to higher prices (easing of yields) as markets expect central banks to start easing interest rates.

However, in the case of West Bengal, we don’t see the logic working. West Bengal has been criticised for its handling of Singur Tata Nano project. As Tatas withdraw from the state, others like Infosys are also planning to withdraw. This will lower investments in the state of West Bengal. Investment is key to growth, and leads to higher employment and higher taxes as well.

THis should have showed in yesterday’s auctionof Bonds (called as State Development Loan) issued by West Bengal. The Bond on offer was for 10 years (all state bonds are mostly of 10 year) and was for 1800 cr.

However, the cut-off yields announced in the auction were 8.80%. The 10 year government bond yesterday was at 8.39%. The difference in yields between a 10 year India government bond and West Bengal government Bond was just about 51 bps.

A pervious West Bengal Bond auction worth Rs 800 cr on 31 July 2008 saw cut-off yields  of 9.90%! The 10 year yields of government bonds then were 9.32% and this implies a spread of 58 bps. The recent sentiment in Bond markets is very bullish and the yield for West Bengal in the latest auction was expected to decline as well. But atleast we should see a higher spread between Centre and State or a lesser easing. The central government 10 year bond yields have declined by 100 bps but for West Bengal it has declined by 110 bps.

So, overall risks for the state of West Bengal as assessed by financial markets have actually declined between July and September. The reality has been a lot different as clearly investment climate has worsened so we should see hardening of yields.

Overall I don’t understand the recent yield movement in goivernment bond markets in India. The markets have been rallying like crazy and yields have been easing sharply. The inflation is still very high and Prime Minister’s team itself said India’s fiscal deficit is much higher than reported. I would again like to reiterate the question I asked in my research paper- Are yields in sync?

Assorted Links

September 10, 2008

1. WSJ Blog points Summers backs a second fiscal stimulus

2. WSj Blog points whether FF mess would turn things around. It points to a new paper analysisng which economic news moves financial markets more.

3. WSJ Blog points to reversal of fortunes in EU economy

4. ACB has an excellent post saying Singur is not the first time for Tatas.

5. CB Blog points the most important price in the world

6. Rodrik posts after a long time and points to the books he has been reading

7. PSD points the Doing Business 2009 has been released. It points google’s new browser-chrome – could be used as a development agency.

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