Leveraging is easy, Deleveraging is a mess

Manmohan Singh and James Aitken of IMF have written a nice paperwhich explains more problems with deleveraging. ( I had warned you that expect a lot of stuff from IMF, they have been doing some great research at a greater pace recently)

The authors looks at the practice of Rehypothecation. It is like a vicious circle. Crisis lowers Rehypothecation and Rehypothecation then leads to deleveraging which then  worsens the crisis. The abstract explains the paper really well.

Rehypothecation is the practice that allows collateral posted by, say, a hedge fund to their prime broker to be used again as collateral by that prime broker for its own funding. In the United Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the customer’s assets. And moreover, there are no customer protection rules (such as in the United States under the Securities Act of 1933). The paper shows evidence that, following Lehman’s bankruptcy, the extent of rehypothecation has declined substantially, in part because investment firms fear losing collateral if their prime broker becomes insolvent. While less rehypothecation reduces counterparty risk in the system, it also reduces market liquidity.

Rehypothecation had increased quite a bit before the boom. One security kept changing hands . In UK Rehypothecation was free for all but there were some restrictions and regulations in US. So as Lehman fell, the customers of Lehman UK were in complete trouble  but some solutions were available for Lehman US. Now as Lehman collapsed Rehypothecation declined as people didn’t accept security collaterals and demanded cash collaterals. This led to a vicious circle as suddenly people either didn’t have enough original good collateral or didn’t have enough cash.

Leveraging is so easy to build but once deleveraging starts (which has to happen as it is a cycle) it poses numerous problems. Another problem of asymmetry in financial markets. As a result, we keep hearing from various economists to put some cap on leverage ratio. It was completely unthinkable till this crisis . As Rodrik puts in this presentation (slide 17):

We can be certain that no future regulation will prevent similar occurrences unless leverage (i.e., borrowing) itself is directly restrained.

A good paper which explores the actual practices in financial markets and then explains the problem.

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How do G7 countries respond in crisis?

In an IMF working paper Daniel Leigh and Sven Jari Stehn have analysed how G-7 economies respond in previous crisis (US, UK, Canada, Germany, France, Italy and Japan). They analyse impact and timing of both monetary and fiscal policy.

Main Findings:

It evaluates whether discretionary fiscal responses to downturns are timely and temporary, and compares the response of fiscal policy to that of monetary policy. The results suggest that while responding more weakly and less quickly than monetary policy, discretionary fiscal policy is more timely than conventional wisdom would suggest, particularly in “Anglo-Saxon” countries, but the response differs substantially across fiscal instruments.

Both fiscal and monetary policy are found to be subject to an easing bias, with more easing during downturns than tightening during upturns; and liable to easing in response to erroneously perceived downturns, many of which are subsequently revised to expansions.

Another shot in the arm for fiscal policy from IMF. The view that fiscal policy is not as bad is gathering pace. It will be a big lesson from the crisis. The other ideas are getting thrashed but fiscal policy advocacy is increasing. And this is not mainly because government spending is the last option that is why we need to build support. But it is being based on some empirical work (however, empirical models themselves are being questioned but am no authority on it).

Anyways, this paper is quite an excellent one which in a snapshot tells you how fiscal/monetary policy has responded in G-7 economies. Apart from this they also point that policies focus more on contraction and relax a bit while economies get back on track. They also suffer from overestimating the downturns and usually do much more than is needed.

Very interesting paper.

Why Larry Summers became an economist?

Noam Scheiber has a written a profile of Larry Summers (which has been discussed quite a bit in blogs). It is interesting throughout tracking Summers’ career from a top academic economist to a top economic policymaker. 

Summers was always slated to become a top economist as both his parents were economists and Ken Arrow and Paul Samuelson are his uncles. However, his take on why he became an economist:

During his senior year of college, Summers was considering graduate school in both theoretical physics and economics. For weeks, he anguished over whether to pursue his passion (physics) or the family business (in addition to his economist parents, Summers has two uncles–Paul Samuelson and Kenneth Arrow–who won Nobel prizes in the field). After he finally decided on the latter, he explained his thinking to Rollins: “What does a bad theoretical physicist do for a living? He walks into an office, sits at a desk, and stares at a plain white sheet of paper.” “But,” Summers added, “there’s a lot of work in the world for a bad economist.”

Fantastic 🙂 Great Read. 

Assorted Links

1. MR says choose a theory.  I vote for Theory 2.

2. WSJB points to Fed Governor Duke’s speech. She syas small banks are lending

3. Peston on how Dunfermline fell

4. JRV points to some interesting papers and articles

5. Indicusblog asks which is bigger real or financial?

Have hedge funds worsened the financial crisis?

I am finding more and more literature to read. I discovered this very useful publication from Riksbank – Economic Review.

Economic Review (earlier Quarterly Review) primarily contains articles on topics relevant to the Riksbank’s field of operation, but also a monetary and exchange rate calendar, tables and diagrams depicting statistics concerning central banks, financial markets balances of payment.

In 2009’s first review has a nice discussion on hedge funds and its role in the crisis by Maria Strömqvist (A short summary is here as well). In sum it says hedge funds have not really played a role in financial crisis. They have been seriously hit by financial market turbulence and earnings have declined. It also points that hedge funds have lower assets under management compared to other investment vehicles (like Sovereign funds) and cannot really disturb markets. Moreover, most hedge funds are pretty small and cannot do damage on their own.

I don’t quite agree. It isn’t really about assets under management but leverage the funds can take up. Even in LTCM case, it was the same leverage which created enough problems. Though the author does point out that leverage is not much of a problem. But then so much is unknown about these funds that we are never sure of their performance and balance sheets. No matter what the arguments, with this crisis we cannot afford to have any secrecy in financial sector anymore.

Anyways a nice lucid read on hedge funds.

IMF Conference on Japan’s experiences

As I said earlier, IMF is on an overdrive at the moment ( I will be posting quite a bit of IMF research papers in days ahead). It organised a seminar on lessons from Japan’s experience.

There are no papers but some interesting presentations. Worth a look.

Assorted Links

1. Krugman points to his research on role of gold, money multipliers in Great Depression. He also points 

magazine cover indicator: when you see a corporate chieftain on the cover of a glossy magazine, short the stock. Presumably the same effect applies to, say, economists!!

2. TTR points to a new job for Plan Com Chief- MSA

3. ACB points should we dump the Rajan and Mistry reports?

4. Urbanomics has some interesting posts on financial regulation – one  and two

5. Nudge points Thaler and Sunstein on Time’s top 100 list.

6. Macroblog on Geithner’s bank-fix plan

7. Mankiw points Zimbabwe’s inflation now depends on Bernanke. He also points to young star econs list.

8. FCB points to new research from Fama/French which shows index funds still rule

9. Zingales (via IGMB) saysGeithner plan is a flop

10. Econb has excellent posts – Fed Monetary Base and Fed Balance Sheet

India’s Inflation: Understanding the sharp fall

I have written a new paper with the same title.

This paper reviews the developments in India’s inflation trajectory focusing on FY 2008-09. Section I shows how volatile inflation has been in FY 2008- 09. Section II presents sector-wise analysis. Section III presents comparisons between WPI and CPI, Revised and Provisional etc. Section IV analyses on whether there is a deflation concern in India

Comments are welcome.

How did India fare in previous crises?

ICRIER has released a new paper updating on Indian economy and financial markets. It forecasts India’s growth rate in 2009-10 at 4.8% without policy response and 5.5% with policies. In 2008-09 the growth is expected to be 6.3% minus or plus the policy response.  They use a leading indicator methodology to predict growth rates which they believe is quite good forecasting tool.

What I find more interesting is their analysis of how India fares in previous global crisis. This paper looks at impact of previous crisis on India’s growth, exports, imports and industry. I had pointed to two previous papers – one on India’s Banking crisis, Great Depression impacting India. This new paper further fills the gap.

The methodology is:

The past crises that have been considered are the three major crises – 1991-92 balance of payment (BOP) crisis; 1997-98 fallout from the Asian financial crisis; and 2000-02 crisis caused by the worldwide bursting of the dotcom bubble and 9/11 incident. The period selected is three years prior to and three years after the worst year of the crisis.

Impact on macro variables

Exports: In the past crises we find that export growth slumped by 12 percentage points during the crises period. But the export sector recovered in just one year after the slump in all the three major crises. The sudden recovery of exports can be due to the huge depreciation that is seen during the crises period.

Imports: import growth starts falling two years prior to the crises. The fall in import growth in the three major crises is greater than the fall seen in export growth. Import growth fell at an average of 14 percentage points and recovery also takes longer than for exports. The sharp depreciation during the crisis period makes the imports more expensive, hence, leading to their prolonged slump. The recovery in the case of imports is longer of a period of two years as compared to just one year in the case of exports.

IIP:As can be seen from the average of past crises, IIP growth in the peak year of the crises has fallen by an average of 3 percentage points, year on year

GDP:  in the case GDP growth we find it falling by about 3 percentage points during the peak crises year

So, it will all depend on whether we are at time T or still T-1 or T-2.  From the graphs ICRIER assumes that 2008-09 is  T-1 and 2009-10 is T (hopefully we will begin to recover from 2010-11 onwards). Let us see how we compare now?

• Exports-Imports have already fallen sharply and I will just compute the numbers to see where are we placed.
• IIP average growth between Apr-08 – Jan 09 is 3.1% and in Apr 07-Mar 08 it was 8.6%. So, it has fallen by nearly 5.5% from T-2 and by 8.4% from T-3. And we are still in T-1. T could be a lot worse. As ICRIER puts it, slip in IIP could be much higher.
• GDP for 2007-08 was 9.0%. In 2008-09 ICRIER expects a growth of 6.3% a slip of 2.7%. In 2010-11, a growth of 5.5% a slip of 4.5%. In previous crisis the growth has fallen by 3% in the crisis year compared to previous years. Here also the impact is more than previous crisis.
• The global crisis seems to be effecting the Indian economy the most. But again, we seem to much better off. The average growth in previous 3 crisis was around 3% but here we are still seeing 5.5% growth in 2009-10.

Interesting analysis from ICRIER. We need more of this to understand how are we placed compared to previous crisis. 

Moveover real and financial crisis, here is trust crisis

I r’ber attending a presentation at college where I was told markets are not about demand, supply or prices. It was completely about trust. You may have all the other three but if no trust markets are not going to be effective. Trust is more crucial in a market for financial products where benefits are going to exist after sometime in future.

It is very interesting to note that two economists – Luigi Zingales of Chicago and Paola Sapienza of Kelloggs are doing tons of research on the subject. They have even developed a index Financial Trust Index:

The mission of the Financial Trust Index is to monitor the level of trust Americans have in banks, the stock market, mutual funds, and large corporations, and to regularly assess how current events, policy and government intervention might affect this trust.

The duo has written numerous papers as well on the subject. Check Professor’s websites for papers.

I just read this paper from the duo which says that trust in financial markets  is very low and has slipped sharply in recent months.

If a modern Rip Van Winkle had fallen asleep two years ago and woken up now, he would wonder what had happened to the U.S. economy. Two years ago, we were in the middle of an economic boom. Banks were eager to lend even at the cost of forgoing important covenants, and corporate America (and the entire world) was producing at full steam, so much so that commodities prices were rising in anticipation of a future scarcity. Today we are quickly sliding into a deep recession. Banks are not lending and commodity prices are plummeting in expectation of a dramatic slowdown of production throughout the world. Neoclassical economic models cannot explain this dramatic change. There was no apparent shock to productivity nor a clear slowdown in innovation. The government has kept taxes low. The Federal Reserve has kept interest rates low and cut them even further. What happened?

What happened?

Something important was destroyed in the last few months. It is an asset crucial to production, even if it is not made of bricks and mortar. While this asset does not enter standard national account statistics or standard economic models, it is so crucial to development that its absence — according to Nobel laureate Kenneth Arrow — is the cause of much of the economic backwardness in the world. This asset is TRUST. As stressed by Arrow: “Virtually every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time.” Without trust, cooperation breaks down, financing breaks down and investment stops.

They then present results of their latest survey. Here are the broad findings:

We find that trust in the financial sector is indeed very low and is reported as having declined sharply in the last few months. This lack of trust is correlated with people’s willingness to invest in the stock market and their tendency to withdraw deposits. While the heavy losses suffered can in part explain this reduced trust, a crucial factor seems to be the way in which the government has intervened. While the majority of respondents favor government intervention in financial markets, 80 percent of the pro-intervention majority think that the way in which the government has intervened in the last few months has made them less, and not more, confident in the market. A big factor in this lack of trust is the perception — shared by 40 percent of the respondents — that the main purpose behind Treasury Secretary Paulson’s act was the interest of Goldman Sachs and not the interest of the country.

Fairly interesting stuff. It looks pretty simple and obvious if we think of it. Trust is going to be broken in times of crisis. A trust crisis simply deepens the crisis.  However, to put it all empirically is really the challenge. The paper was written when Paulson was the Treasury Secretary. It will be interesting to see where the index is headed now. I think it would have slipped even lower since then.  The policies have only gone worse and moreover it is Paulson’s earlier policies which are making a comeback.

It is interesting to note that economists are now researching in areas which were assumed as given. Behavioral economics has made leaps of progress to show humans are anything but rational. Then there is ongoing research on neural economics.  And now this research on trust.

The way economics concepts and theories are being questioned now (by really big names like Greenspan, Acemoglu, Willem Buiter etc) it will be interesting to see which other areas would field of economics move into? It is surely an exciting time for economics research. Thinking differently may not have been appreciated earlier, but looks set to be rewarding now.

Research on Measuring Financial Integration and whether SWFs help?

I had recently posted on the need to have better measures to find out how much an economy is financially integrated with rest of the world.

IMF in its March research bulletin has an interesting lit survey by Martin Schindler:

Over the past several years, an increasing number of  such measures have been made available, including de jure measures, aiming to reflect the extent to which countries impose legal restrictions on cross-border financial flows, and outcome-based de facto measures, aiming to capture a country’s actual degree of financial integration. For the purpose of policy analysis, de jure measures, which are under policymakers’ direct control, are more relevant, while in other applications, de facto measures may be more appropriate; in still other situations, both may be necessary, for example, if the research question centers on the effectiveness of capital controls in stemming de facto outcomes.

He then explains the various databases developed by economists. He summarises it as:

Overall, a wide array of measures exists from which researchers can choose those that best fit their research question. For example, the inflow/outflow distinction in Schindler (forthcoming) allows Prati, Schindler, and Valenzuela (forthcoming) to identify the differential effects of capital account liberalizations on different subsets of firms; Binici, Hutchison, and Schindler (forthcoming) use both de jure (Schindler, forthcoming) and de facto (Lane and Milesi-Ferretti, 2007) measures and find significant differences in the effectiveness of capital controls between equity and debt flows and inflows and outflows; and Kose and others (2006) argue for the use of de facto measures. For further discussion of financial integration measures and related issues, researchers are referred to Edison and others (2004), Kose and others (2006), Miniane (2004), and Schindler (forthcoming).

The bulletin also carries a lit survey on whether Sovereign Wealth Funds help or worsen financial markets. It looks at research papers (though limioted data is not public) which have used event studies. Findings:

Overall, these event studies do not find any significant destabilizing effect of SWFs on equity markets. It will be hard to draw conclusions for overall global and regional financial stability or stability in markets other than equity markets from these event studies. Other methods to examine the empirical impact of SWFs would require more detailed knowledge of SWFs’ investments and their timing and amount—data that is presently not available. Hypothetical market responses to SWFs’ investments require a thorough understanding of how asset allocations are constructed and the size, depth, and breadth of the corresponding markets.

To summarize, existing research on SWFs suggests that they can be a stabilizing force in global financial markets. Event studies do not find a destabilizing impact from SWF investments and divestments in equity markets, while simulations of SWF asset allocations only imply a gradual shift with modest economic effects. With SWFs improving their transparency and disclosure over time, the availability of historical SWFtransactions would provide researchers with the necessary data to further examine their implications for financial stability.

Superb short readings.

Assorted Links

1. Urbanomics summarises various views on the new Geithner plan

2. Krugman says he is only human 🙂

3. Mankiw advertises for the IMF

4. Finprof points to Hernando De Soto’s analysis of the crisis

5.  Pestonblog points that the recent failed auction of UK G-sec is a cause for concern

6. CTB says monitoring leverage ratios is useful

For AIG bonuses blame the Connecticut law

I had pointed earlier:

House Committee on Financial Services has started a two part hearing. In first part AIG CEO talks and in second Bernanke and Geithner would present their views (25 March 2009). The first part hearings are available on the website

The second part of hearing is here and is being discussed widely in blogs and media.

Geithner says:

On March 10^th, I received a full briefing on the details of AIGFP’s pending retention payments, including information on the payments to individual executives.

I found these payments deeply troubling.  After consulting with colleagues at the Fed and exploring our legal options, I called Ed Liddy and asked him to renegotiate these payments.  He explained that the contracts for the retention payments were legally binding and pointed out the risk that, by breaching the contracts, some employees might have a claim under Connecticut law to double payment of the contracted amounts.

Bernanke says:

I asked that the AIG-FP payments be stopped but was informed that they were mandated by contracts agreed to before the government’s intervention. I then asked that suit be filed to prevent the payments. Legal staff counseled against this action, on the grounds that Connecticut law provides for substantial punitive damages if the suit would fail; legal action could thus have the perverse effect of doubling or tripling the financial benefits to the AIG-FP employees.

It seems lots of work has gone in structuring compensation schemes, ensuring the flow continues whatever happens

Comparing Fed, BoJ and ECB

I have pointed to number of papers comparing monetary policy between Fed and ECB ( See this, this, this and this).

I came across another paper from the trio Dieter Gerdesmeier, Francesco Paolo Mongelli and Barbara Roffia which compares Fed, ECB and Bank of Japan.

Key Findings:

This paper has analysed the similarities and the differences among the  Eurosystem, the Fed and the BoJ. It finds that, while several of their tasks and their respective legal statuses differ somewhat, there are fewer differences in their institutional structures and monetary frameworks, as well as the use of instruments. Central banking practices around the world have also evolved in the di rection of greater independence, transparency and the adoption of monetary policy committees, among other developments. This has contributed to reducing the differences among the three institutions, a trend that can also be observed among other central banks.

There are, however, some de facto differences in the way monetary policy committees operate.  For example, when taking monetary policy decisions, both the Governing Council of the ECB and the Board of Governors of the Fed officially act by simple majority voting. In practice, both the Governing Council and the FOMC operate as collegial committees. Yet, while the former functions as a genuinely collegial committee practising consensus voting, in the latter the chairman has scope to steer the agenda very tightly. The Policy Board of the BoJ, by contrast, operates in a much more individualistic manner than the other two.

There are also some differences in terms of communication strategie s, although, overall, the  responsiveness of the financial market seems high for both the Eurosystem (concerning monetary policy inclinations) and the Fed (regarding monetary policy inclinations and views on the economic outlook). However, the Fed does not quantify its definition of price stability, whereas the ECB and the BoJ do. Nor does it spell out a fully fledged monetary policy (again in contrast to the ECB and the BoJ). The ECB does not publish the minutes of its Governing Council meetings, unlike the Fed and the BoJ.

As for the economic and financial environment, over the past two decades all three central banks have faced a series of diverse challenges, some of them country-specific (as in the case of Japan), and others more global in nature. Early in the sample period, conditions differed considerably in the three currency areas, with a much higher dispersion among euro area.

A comparison based on a very simplistic policy reaction function framework à-la-Taylor shows no striking differences in the implementation of monetary policy. It can, therefore, be concluded that, in practice, the monetary policies of the Eurosystem, the Fed and the BoJ(if we exclude the more recent challenging period) fundamentally do not differ that much.

Excellent stuff.

Monetary Policy under ZIRP

Lars Svensson of Princeton Univ and Deputy Governor Riksbank has done loads of research on Zero Interest Rate Policy (ZIRP).  He has given a nice speech summarising the issues and various research on the subject.

Assorted Links

1. WSJ Blog points to Kansas Fed chief  views on Fed operations

2. Mankiw pointsto a pessimistic forecast from Reinhart-Rogoff duo

3. Stephanomics on recent Governor’s remarks

IMF says imposing capital controls could be considered!

IMF has been quite active recently hosting seminars, updating forecasts, new publications etc. I came across this IMF note titled Initial Lessons of the Crisis (there is another one titled “Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management” ).

This note is a good honest appraisal of IMF of its work and views.

Fed Treasury Accord revisited?

I had pointed earlier that leading US policymakers are asking to revisit Fed-Treasury Accord. The Accord signed in 1951 led to independence of Fed and made Fed responsible for monetary policy. In this crisis, Fed has increasingly taken roles of Treasury and this has led experts to revisit the accord in order to send signals that independence of Fed will not be undermined.

Seeing these calls, Fed/Treasury have issued a joint press release which clarifies that Fed is responsible for monetary policy and not selective credit policy.

This joint statement reflects the common views of the Treasury and the Federal Reserve on the appropriate roles of the Federal Reserve and the Treasury during the current financial crisis and in the future and on the steps necessary to ensure that both financial and monetary stability will be achieved. 

They agree on following 4 points:

1. Treasury-Federal Reserve cooperation in improving the functioning of credit markets and fostering financial stability
2. The Federal Reserve to avoid credit risk and credit allocation
3. Need to preserve monetary stability
4. Need for a comprehensive resolution regime for systemically critical financial institutions

In the end it says:

In the longer term and as its authorities permit, the Treasury will seek to remove from the Federal Reserve’s balance sheet, or to liquidate, the so-called Maiden Lane facilities made by the Federal Reserve as part of efforts to stabilize systemically critical financial institutions.

Nice to see this development as it leads to some resurrection of Fed image which has been battered badly in this crisis. The Treasury should also walk the talk by issuing further statements on how the various facilities will be removed from Fed’s balance sheet.

Bank of Japan, Bank of England have also started buying fancy assets and would be good if they issue statements like this as well. Central Bank independence is something that needs to be preserved highly in the crisis.

Assorted Links

1. Krugman on the new Geithner plan. WSJ Blog points to expert’s comments on the new plan. Mankiw comments as well Finprof Blog points to economists clashes

2. Macroblog analyses  BOE’s growing balance sheet

3. CTB on stingy europeans

4. MR says someone has to be wrong

5. Indicus Blog says it is price correction not deflation

Summary of Japan’s woes in crisis – 2007-?

IMF has started a new series of policy research papers- Staff Position Notes. Each of the papers are worth reading as they are contemporary and simple to read. The papers have been widely discussed as well. The first paperis a look at fiscal policy to solve the crisis, second one raises deflation risks for Japan and US, Fourth one is IMF’s case for a global fiscal stimulus etc etc.

The recent paper (6th in the series) is a nice brief on why Japan has been hit so hard because of the global crisis.

• Trade Channel: It is mainly because Japan has been export driven. Japanese exports are advanced manufactured products like cars, IT, machinery ets. As global economy slumped, so did demand for Japanese exports.
• Finance Channel: The global financial crisis led to concerns at Japanese fin markets as well leading to worsening of trade channel

This is all pretty well known. However, the paper has numerous graphs to tell the story. The first chart is particularly interesting. It plots the GDP growth with share of high tech exports as a % of GDP. The result is quite starking. The economies that have higher share of high tech exports as a % of GDP show the highest decline in their GDP as well (Korea, Taiwan, Japan etc).