Archive for December 2nd, 2008

Using CDS to make companies insolvent

December 2, 2008

I came across this article in FT by Mark Sunshine, President and COO of First Capital. He points to a practice in financial markets that uses CDS and bets on making companies insolvent. The modus operandi in short is :

Recently, it was reported that banks have started tying commercial loan interest rates to the price of a borrower’s CDS. This seemingly innocuous loan provision allows speculators to bet that a borrower’s stock price will go down while insuring that the bet pays off by manipulating the borrower’s CDS prices upward

The article explaisn with help of an example as well. Intersting application of CDS !

Financial Crisis curtails freedom of speech!

December 2, 2008

I came across this article in WSJ (Thanks to Krugman for the pointer) which reports:

Hammered by economic woe, this former Soviet republic recently took a novel step to contain the crisis. Its counterespionage agency busted an economist for being too downbeat.

“All I did was say what everyone knows,” says Dmitrijs Smirnovs, a 32-year-old university lecturer detained by Latvia’s Security Police. The force is responsiblefor hunting down spies, terrorists and other threats to this Baltic nation of 2.3 million people and 26 banks.

Now free after two days of questioning, Mr. Smirnovs hasn’t been charged. But he is still under investigation for bad-mouthing the stability of Latvia’s banks and the national currency, the lat. Investigators suspect him of spreading “untruthful information.” They’ve ordered him not to leave the country and seized his computer.

The article further says Latvian agencies are fairly particular about people saying bad things about its economy and banks. This makes banning short-selling a cakewalk really.

This Latvian case reminds me of allegation by Richard Fuld (ex CEO, ex Lehman) that rumors led to collapse of Lehman. I thought that was pretty absurd and what can one say of this? If Latvian Banks are badly placed (as per reports they are), should someone still say they are good?

Juris Kaza, a jouranalist has developed a blog to provide updates on the matter

Literature Survey on Financial Globalisation

December 2, 2008

Maurice Obstfeld has written a nice literature survey on the subject for Growth Commission. The paper is here. What are the main findings?

Particularly at the macro level, it is hard to find unambiguous evidence that financial opening yields a net improvement in economic performance for emerging countries. The major problems in empirical evaluation are the bundling of financial opening with a potential host of other growth-friendly reforms, and the endogeneity of the liberalization decision itself. Microeconomic evidence may provide less ambiguous evidence, but even in the micro context identification problems can remain.

In sum, empirical evidence is not conclusive that opening up financial markets leads to growth. What is the practical reality?

Nonetheless, policymakers in emerging markets have displayed a remarkable revealed preference for financial openness, and the trend is likely to continue (perhaps with occasional seizures when global economic conditions sour). Why?


Domestic financial development is attractive from several perspectives – it promotes growth, can enhance welfare more generally, allows easier government borrowing, and eases the conduct of a domestically oriented monetary policy. Such domestic financial deepening, along with merchandise trade expansion, makes capital controls ever costlier to  enforce. Furthermore, financial opening is likely to promote, through several channels, a more competitive and resilient domestic financial system.

The findings are quite similar to what Rogoff et al say in their paper. In that paper they review tons of literature and say the same – Though, there is little evidence whether capital flows help in growth, one should go ahead with financial globalisation. Why?  Because it has collateral benefits – development of the domestic financial sector, improvements in institutions, better macroeconomic policies etc. These collateral benefits then result in higher growth, usually through gains in allocative efficiency.

Then Obstfeld says:

Domestic financial development itself is likely to make external financial liberalization easier to live with. But there are other institutional reforms that ultimately are also helpful – relating to the rule of law, corruption, contract enforcement, corporate governance, and the like. These reforms cannot be accomplished overnight, and in the process, a phased and cautious piecemeal approach to liberalization is in order.


Again we have the complete list of reforms needed to make financial globalisation work. Hence the first focus has to be on setting domestic things right as that is the main problem.

The conclusion that financial integration is inevitable, and eventually even helpful, is in line with a classic insight from the trade policy literature: the efficient way to correct a distortion is to attack it at to its source. In the present setting, domestic financial market imperfection and institutional weakness, not financial openness, is the primary problem. The ideal response would be a correction of domestic imperfections plus intervention to address the specific additional issues raised by the international margin. Only if this approach is unworkable might a closed financial account be the answer.



This is pretty well-known and nothing new really. Actually the nature of financial globalisation is itself so complex, that any concrete analysis is difficult to arrive. These literature surveys are very useful to get a picture of what different studies have found.  In this regard, this Obstfeld paper is very useful.

Deflation or an unwelcome fall in inflation?

December 2, 2008

Bernanke has given some landmark speeches in his career as a Fed Governor and now Chairman. Though , much of his speeches are now testimonies on Economy and Financial Market Outlook. As a Governor, he had given some high quality speeches on an economic/finance issue. And the quality was so high that it could easily become a reference research paper on the topic.

In current times, his 2 speeches are worth reading. One on Deflation (21 Nov 2002) and other on sharp fall in inflation (23 July 2003; he titled his speech as An unwelcome fall in inflation).

The Deflation one has become part of economic folklore with most economists citing Bernanke’s speech to understand deflation and policy options to manage it. Infact, Mankiw points Bernanke is trying to walk his speech to avoid deflation in the economy. However, few think word deflation (read this superb Bin Smaghi speech on the topic) should be used carefully and it does not look like happening.

Whether deflation will happen or not would depend on a number of factors. However, what is certain is the sharp fall in inflation across economies(though in India CPI continues to rise). If this sharp fall in inflation starts getting reflected in inflation expectations as well (as in people start expecting prices to decline), then chances  of deflation become very high.

How do we analyse this fall in inflation? It is in this respect his second speech is quite useful. The speech actually explains the FOMC statement in May 6 2003:

Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.

Would Fed use similar words on inflation (as there are hardly any upside risks to growth) in upcoming FOMC meeting on Dec 15-16, 2008 as well? In its previous FOMC statement (Oct 29 2008) it says:

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

However, the recent numbers are anything but moderation in inflation. What we are instead seeing is a sharp fall in inflation which is clearly unwelcome. In the speech Bernanke says inflation outlook in medium term depends on  factors:

1. Economic slack
2. Inflation expectations.  
3. Supply shocks, such as changes in energy prices, food prices, or import prices. 
4. Inflation persistence.

Bernanke says out of the four, it is Economic Slack which is expected to be much higher and this would result in fall in inflation (disinflation).

The same can be applied in these times as well.Infact, in this crisis all the 4 factors are much worse than in 2001.  Hence, all 4 factors indicate that we are going to see sharp fall in inflation going ahead. However, as Fed has eased its mon policy substantially, whether it turns into a deflation is yet to be seen.

Assorted Links

December 2, 2008

1. WSJ Blog points Recession is official now. Econbrowser has an interesting post on the same

2. MR points to FDIC history

3. Krugman points to Adam Posen book which has literature on fiscal policy

4. Mankiw has an excellent post on fiscal policy puzzles. These are basics. He also has a useful post on budget deficit.

5. GCB points how Africa can become America?

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