Archive for December 11th, 2008

Stiglitz’s 5 key moments that led to crisis

December 11, 2008

Joseph Stiglitz in an article on Vanity Fair puts the crisis to 5 key moments:

No. 1: Firing the Chairman (Volcker that is)
No. 2: Tearing Down the Walls
No. 3: Applying the Leeches
No. 4: Faking the Numbers
No. 5: Letting It Bleed

And then he says all the 5 mistakes lead to one single point:

The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. Looking back at that belief during hearings this fall on Capitol Hill, Alan Greenspan said out loud, “I have found a flaw.” Congressman Henry Waxman pushed him, responding, “In other words, you found that your view of the world, your ideology, was not right; it was not working.” “Absolutely, precisely,” Greenspan said. The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today.

Powerful words from as powerful an economist.

Swiss central bank – first to move interest rates below 1%

December 11, 2008

We are staring at 0% interest rates across number of economies. Infact, there is a race on who reaches the target first.

Switzerland appears to be winning the race (Atleast it has made the move first)

The Swiss National Bank (SNB) is lowering the three-month Libor target range by 50 basis points to 0.0–1.0% with immediate effect.

The global economic environment has sharply deteriorated over the past few months. Economic activity has declined in both the US and Europe, and has slowed considerably in Asia. The situation on international financial markets has worsened further since September. The Swiss economy will be heavily affected by these developments. The SNB projects that GDP growth will be negative next year, between –0.5% and –1%.

The unfavourable economic outlook and the falling oil price have prompted a radical adjustment of the inflation forecast. Inflation will undergo a substantial decline over the course of next year, and will remain low thereafter. Assuming a constant rate of 0.5% for the three-month Libor, the SNB is now forecasting average annual inflation of 0.9% in 2009 and 0.5% in 2010.

SNB has a different mon policy strategy:

The SNB implements its monetary policy by fixing a target range for the three-month Swiss franc Libor, which it publishes regularly. As a rule, this target range extends over one percentage point, and the SNB generally aims to keep the Libor in the middle of the range.

On 20 Nov 2008 SNB had lowered the targeted range by 100 bps to 0.50% to 1.50%. Ideally 3 month Libor should be at 1.00%. This file shows that from 20 Nov 2008, 3 month Libor range has been around 1.30% – 1.14% and has declined gradually. From 11 Dec 2008 onwards it should be within 0% to 1.00%. ( For lowering rates SNB supplies liquidity to money markets and vice-versa)

The next lowest rates are in US with fed funds rate placed at 1.00% and is expected to be slashed to 0.50% in next meeting on 15- 16 December 2008. This is expected to be followed by Bank of England, ECB, Riksbank etc etc.


I missed Japan which has the lowest rates – 0.30% right now and is expected to be 0% soon. However Japan doesn’t come to mind as it has always been around 0% for so many years now.

China, Taiwan and Korean Trade falls from a cliff

December 11, 2008

The recent export-import data from China, Korea and Taiwanshows the crisis has become much deeper. Earlier we saw the crisis impacting only the financial channel, but now it is impacting the trade channel fully (see a review of these channels here). Economist has an excellent review of recent China trade data and world trade situation.

  • China- exports declined by 2.2% in November compared to November 2007 (also called as year on year growth), ; imports by 17.9%
  • South Korea- exports declined by 18.3% in November (year on year); imports by 14.6%. Exports climbed 8.5 percent in October and 28.2 percent in September.  As a result, Korea cut rates by 100 bps
  • Taiwan-  exports declined by 23.0% in November

What is more worrisome is the sharp fall in trade data. Like the inflation data trade data is falling from the cliff. These are all export driven economies and it clearly suggests economic activity is weakening considerably now. Moreover, exports contribute almost 30% of the world growth and this does not look good at all now.

India also saw a sharp decline in exports and imports in month of October. Exports declined by 12.1% and imports grew at 10.6% (in September it was 10.4% and 43.3% respectively). It looks like we are staring at much worse number from Nov onwards.

Hold on to year seat belts as they say.

Taleb blames portfolio theory; Markowitz defends it

December 11, 2008

Mckinsey Quarterly has an excellent interview of Nassim Nicholas Taleb, author of the revered book- Black Swan (free subscription required). He says Black Swans are of both types – positive and negative. We should we be careful of latter and be more risky towards former.

What caught my eye was this:

The Quarterly: You question many of the underpinnings of modern financial theory. If you were the dean of a business school, how would you overhaul the curriculum?

Nassim Nicholas Taleb: I would tell people to learn more accounting, more computer science, more business history, more financial history. And I would ban portfolio theory immediately. It’s what caused the problems. Frankly, anything in finance that has equations is suspicious. I would also ban the use of statistics because unless you know statistics very, very well, it’s a dangerous, double-edged sword. And I would ban linear regression. All these things don’t work.

(emphasis is mine)

The Quarterly: What are your concerns with statistics and portfolio theory?

Nassim Nicholas Taleb: The field of statistics is based on something called the law of large numbers: as you increase your sample size, no single observation is going to hurt you. Sometimes that works. But the rules are based on classes of distribution that don’t always hold in our world.

All statistics come from games. But our world doesn’t resemble games. We don’t have dice that can deliver. Instead of dice with one through six, the real world can have one through five—and then a trillion. The real world can do that. In the 1920s, the German mark went from three marks to a dollar to three trillion to a dollar in no time.

That’s why portfolio theory simply doesn’t work. It uses metrics like variance to describe risk, while most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk. It’s very foolish to use variance.

 This is pretty straight forward. Taleb’s criticism for portfolio theory and modern finance is well known. In this FT article he criticised the Nobel Committee for crowning the finance theories.

I also came across this recent piece from Harry Markowitz (Father of Portfolio Theory) where he defends portfoilio theory:

The  second objection might go like this, “You, Harry Markowitz, brought math into the investment process with your 1952 article and 1959 book. It is fancy math that brought on this crisis. What makes you think now that you can solve it?”

This objection fails to distinguish between my contribution, portfolio theory, and a later development, financial engineering. A typical application of portfolio theory chooses a portfolio similar to a 60-40 or 70-30 or even 80-20 mixture of stocks and bonds, but more sophisticated, combining more asset classes in a way that minimizes risk for a given level of return on the average.

Financial engineers create new financial instruments from old. This can be a good thing—not all financial engineering is always bad—but the layers of financially engineered products of recent years, combined with high levels of leverage, have proved to be too much of a good thing.

Neither my own portfolio, nor those which my clients supervise or advise nor, to my knowledge, any of the large institutional investors (e.g., pension funds) who apply portfolio theory in a generally accepted manner, have suffered excessively from the crisis of the last thirteen months. Most have lost of course. It is part of a risk-return view of portfolio selection that if you want more return on average, and you proceed efficiently, you will have to accept greater fluctuations in the short run.

This is interesting – difference between portfolio theory and financial engineering. Markowitz says portfolio theory if used properly does not damage as much (if you take higher risks you have to bear with higher losses and vice-versa) but same cannot be said for financial engineering.

Everyone needs to play their part

December 11, 2008

RBNZ Governor Alan Bollard in his speech summarises the developments in NZ economy. He says inflation is still very high but things look better as prices are falling sharply. He then says:

We need to see inflationary pressures reducing significantly across the board, if we are to keep on easing monetary policy, thus helping the New Zealand economy to recover. That depends on all sectors of the economy responding to the reduced demand and not adding inflationary pressures to the system.


Some examples: we would hope that the electricity industry does not take advantage of its market position and keep increasing rates, that local authorities realise they need to set rates increases below inflation for a change, that the construction materials industry respond to much weaker demand, that the food industry react to lower international commodity prices with price cuts, that petrol companies keep cutting forecourt prices, that the transport industry pass on fuel price cuts, and that the banks pass on interest rate cuts. Only then will all these firms be playing their proper role in New Zealand’s recovery.

These are actually desperate calls for the NZ industry to get its act together and pass-off lower prices to the consumers. One hears these statements so often from policymakers across the world these days. I would think let markets take their own call on what to do and what not to do. If you believe markets perform well in good times they should do the same in bad times as well.  

Assorted Links

December 11, 2008

1. Krugman on the German problem. He also points that stock markets might collapse further

2. MR points to Krugman’s Nobel Prize lecture and scary forecast

3. WSJ Blog points to leaks in US economic data system

4. NB points to a nudge forum to address the crisis

5. Mankiw points leave auto industry, Italians are trying to save parmigiano cheese indsutry!

6. Macro has an excellent post on trade finance

7. CTB on bankruptcy

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