Archive for May, 2009

Fed regionwise analysis of US recession

May 29, 2009

We usually analyse US economy on an aggregate basis. However, a state-wise/region-wise provides more clarity on where the issues are greater or lesser.

I came across this excellent analysis by Chad Wilkerson of Kansas Fed where he studies this recession and previous post war recession on the basis of Fed regions. As we know, Federal Reserve is divided into 12 regions, so this study tells you which area recession is more severe, less severe, where it started before the national average etc etc.

It has excellent insights as he looks into the industrial structure of each region to determine the severity of recession. Some regions are commodity industry based, some manufacturing based, some services based etc. Hence the impact on each region would be different.

The document does not allow to copy esxtracts, so cant paste from the document to explain. Read the superb paper for details.


Six principles for Fed-Treasury Accord

May 29, 2009

Princeton Univ organised a conference – Monetary-Fiscal Policy Interactions, Expectations, and Dynamics in the Current Economic Crisis. It has some superb papers by some top econs.

For instance this paper (too technical for me, so left it midway) says most papers on fiscal mutliplier do not consider the zero-bound monetary policy situation (for instance see this paper presented in the same conference). As a result, we get fiscal multipliers much lower and it is not a multiplier at all (see this for a review). However, if we take a zero bound mon pol situation, fiscal multiplier is much larger (though I don’t think they give a precise number as it is still preliminary).

In this paperMarvin Goodfriend provides 6 principles for Fed-Treasury accord for fixing the credit policy used by Fed.

The Fed should adhere to a “Treasuries only” asset acquisition policy except for occasional and limited discount window lending to depository institutions deemed to be solvent.

The Treasury and the Fed should agree to cooperate, as soon as the current credit turmoil allows, to shrink the central bank’s lending reach by letting Fed credit programs run off or by moving them from the Fed’s balance sheet to be managed elsewhere.

The Treasury and the Fed should cooperate to guarantee that the use of monetary policy for the fiscal purpose of funding credit policy does not undermine price stability.

To strengthen the nation’s commitment to price stability, the Treasury and the Fed should agree on a low long run inflation objective.

The Treasury should help the Fed, by seeking congressional legislation if necessary, to secure the capacity of interest on reserves to provide a fully credible exit strategy from the zero bound on interest rate policy, regardless of the Fed’s credit policy commitments or the size of its balance sheet.

The credibility and effectiveness of monetary policy to act aggressively against deflation at the zero bound requires that the Fed and the public are both confident that interest rate policy can exit the zero bound promptly and aggressively against inflation if need be, whatever the Fed’s credit policy commitments.

Other papers in the conference also look quite good.

A quick overview on Global Central Bank Policies

May 29, 2009

Ric Battellino, Deputy Governor of RBA gives a short overview on what central banks have been doing globally.

This is quite a statement:

The unusual period of monetary policy began in September 2008, after the failure of Lehman Brothers dramatically escalated the financial crisis. This in turn led to a collapse of household and business confidence around the world. Official interest rates have since been cut very sharply across virtually all countries due to the highly synchronised nature of the current economic cycle. The average reduction in interest rates has been 330 basis points in the developed economies and about 300 basis points in emerging economies. Among the developed economies, only four – Australia, New Zealand, Denmark and Norway – still have official interest rates above 1 per cent. Official interest rates have never been this low in the developed world in the 150-year period for which we have data (Graph 1)

We keep hearing theese are the lowest interest rates in UK, Euroarea (in ECB’s history) etc. Now here they calculate median interest rates of US, UK, Japan, Germany and find the rates to be lowest in 150 years!!!

What is the use of Planning Commission now?

May 28, 2009

I don’t know whether people have noticed the speeches page of Montek Singh Ahluwalia at Planning Commission’s website. It has some excellent speeches on India’s growth history, economic issues, policy challenges, Indian economic history etc etc

In one such speech he looks at the role of Planning Commission (PC) then and now. Though, it is not discussed anymore now the issue of relevance of PC in these times was a raging debate in early 2000s.

First a bit of history:

Amartya Sen’s article, which is reprinted in this volume but which first appeared in the Seminar issue on Freedom and Planning almost fifty years ago, provides a flavour of the earlier approach. Sen argued then that planning was necessary not only to achieve distributional objectives – which he points out is a traditional and much discussed basis for state intervention – but also to achieve a high rate of growth. He recognized that the industrialized world had achieved industrialization without planning and acknowledged that we could also follow this path, but warned that if we did, it would take us more than a hundred years to industrialize whereas the experience of the socialist economies showed that a much faster transition was possible with socialist planning.

The superiority of socialism in achieving rapid growth was attributed to two reasons. First, since capitalists seek profit maximization, growth in a capitalist economy is only a by-product of this process, and therefore need not occur at the fastest possible rate. Second, even if capitalists want to maximize growth, they would be less efficient at doing so because individual entrepreneurs do not have all the information necessary to achieve the best results whereas a ‘national coordinating planning organization’ would have much more information and therefore achieve better ground outcomes.

 Sen also warned that planning as practised in India, without a really socialist economy, with a private sector responsible for producing consumer goods and a public sector concentrating on producer goods, was unlikely to achieve results. The model suffered from internal contradictions – the ‘middle path’, as he put it, had run out and it was necessary to take a stand on whether we really wanted a socialist economy. The case for planning was essentially a case for more comprehensive socialism, and was in his view a strong case, but we would need to move to a socialist economy.

 Wow! This is great insights. PC got a thumbs up from Dr Sen but not the Indian economic model. He would have preferred a completel state control to acheive desired results. Dr Sen got the first prediction wrong and second one right:

Things have changed enormously in fifty years and not surprisingly attitudes to planning have also changed. The greatest change in perceptions that has occurred since Sen’s Seminar article of fifty years ago is the discrediting of the technical argument that a centralized planning system, led by a ‘a coordinating national planning organization’ would be more able to achieve faster growth. The costs of a centralized system of decision-making, relative to a decentralized approach of ‘letting a hundred flowers bloom’ are now much better appreciated. Centralization is of course particularly dangerous where governance is poor but even when governance is not a serious problem, centralization is likely to be inefficient because bureaucratic decision-making….

Sen proved prescient, however, in the doubts he expressed in 1959 about the effectiveness of planning as practised in India and his misgivings were largely borne out over the next twenty years. Indian planning did not succeed in achieving even moderate targets of five per cent growth set in the early five year plans. Doubts also began to be aired about whether such growth as was taking place was reaching the poor. Prime Minister Jawaharlal Nehru himself, while introducing the Third Plan in Parliament in August 1962, said that per capita income had increased but ‘a legitimate query is made. Where has this gone?’ He went on to observe that he could see that people were better fed and clothed but ‘that does not apply to everyone. Some people have hardly benefited. Some people may even be experiencing various difficulties.’

Some things have hardly changed. W estill face the same problem now. Despite 9% growth rate in last 4 years, we still ask – “Where has this gone”?

Anyways, now back to the original question. What is the use of PC now? He says it is for indicative planning purpose:

By indicative planning, I mean defining broad national goals and objectives, and presenting an internally consistent picture of the evolution of the economy in a manner which achieves these national over a defined time horizon. In India, for example, if we could set the goal of achieving some target level of per capita income over a specified period – say increasing our per capita income from $1000 today to $5000 over 20 years combined with corresponding improvements in the access of the population to a basic minimum level of living over this period. Indicative planning can then be used to outline broad challenges in achieving this goal.

He then lists areas where indicative planning is useful. Read the rest for details.

Differences on Fed, ECB and BOJ intervention in financial sector

May 28, 2009

Masaaki Shirakawa, Governor of the Bank of Japan in his recent speech explains the reasons for differences between the 3 central bank policies for financial sector support:

At the end of 2007,  the ratio of bank lending relative to nominal GDP, which can be used as a guide to capture the differences in the structure of financial intermediation, was 63 percent in the United States, 145 percent in the euro area, and 136 percent in Japan. On the other hand, the ratio of outstanding bonds issued by the private sector relative to nominal GDP was 168 percent in the United States, 81 percent in the euro area, and 94 percent in Japan. As these figures show, the role of financial intermediation in the United States is carried out mainly by the capital markets, whereas in the euro area it is bank lending. Japan comes in between the United States and the euro area, but the share of bank lending is relatively high.

Reflecting these differences in the structure of financial intermediation, the Federal Reserve has been conducting large-scale purchases of assets such as CP and real estate mortgage-backed securities (RMBS) directly in the markets to restore the functioning of capital markets. The Federal Reserve calls it a “credit easing policy.”

On the other hand, the European Central Bank (ECB) has introduced measures to restore the financial intermediation function of banks. Specifically, the ECB has expanded the range of eligible collateral that banks can submit in order to acquire funds from the central bank, and has been providing banks with unlimited amount of longer funds up to the value of eligible collateral at a fixed interest rate.

Meanwhile, the Bank of Japan has been taking actions to both restore the functioning of the markets and strengthen the financial intermediation function of banks. In the area of restoring the functioning of capital markets, the Bank has been conducting outright purchases of CP and corporate bonds through banks, although the scale of purchases is small relative to the United States where the degree of impairment of market functioning has been substantial.

In addition, in the area of strengthening the financial intermediation function of banks, the Bank, similar to the ECB, has been expanding the range of eligible collateral, and has also been providing long-term funds at low interest rates against corporate debt submitted as collateral. Through these measures, the Bank is aiming to facilitate smooth extension of bank credit.

Hmmm. This broadly sums up the reasons for differences in financial sector policies of the 3 central banks. Great insight…

A Balance Sheet crisis in India??

May 27, 2009

A random google search bought me to this paper which was an immediate read . The paper’s title is same as the post and needless to say the paper is quite stimulating. It was written in 2004  and needs to be updated with 2009 figures. Though, on reading it one does not see much changing even when we update the figure(hope i am wrong).

The paper is written by Nouriel Roubini and Richard Hemming. Roubini along with other economists pioneered balance sheet approach (see this paper as well)  to understanding crisis in emerging economies (though the most imp purpose is to predict the crisis in advance but predicting a crisis is quite difficult).

The paper looks at balance sheet issues in India. I will just point to the conclusion as it has all the juice:


Who did it? Markets or Government?

May 27, 2009

John Taylor has been criticising Fed since the crisis began(see this for a review). In another paper he criticised the US govt for overestimating the fiscal multiplier.

Taylor in a recent speech (at FRB Atlanta Conference)  takes a critical overview of the entire govt policies in this crisis. He says:


Forward looking forecasts vs backward looking forecasts

May 26, 2009

Charles Plosser of Philadelphia Fed in his recent speech speaks on output gaps. He is more optimistic on growth outlook than others:

Thus, while forecasting in the current environment is tricky, many forecasters, myself included, expect the second quarter of this year to exhibit a less severe decline in real GDP. Yet, I remain relatively optimistic and expect positive but modest growth in the second half, making fourth-quarter to fourth-quarter real GDP growth only slightly negative for 2009.

I am also relatively optimistic about growth next year. In fact, since January, I have not changed my growth forecast for 2010 or 2011. I expect the recovery to gain traction in 2010, with growth picking up to about 3 percent and then settling down to its long-run steady state of about 2.7 percent in 2011.

And the reasons are:

The broad outlines of this forecast are shaped by a view that the economy has suffered from a significant and persistent adverse shock to financial intermediation, manifesting itself in the form of the credit crisis. The consequences of this shock require significant real adjustments in the economy. For example, we are undoubtedly seeing a shrinking of the financial and housing sectors, and resources, both labor and capital, should flow into other parts of the economy. We cannot and we should not attempt to prevent these reallocations.

This suggests that the appropriate measure of the equilibrium level of national output is now lower than it had been previously. What’s more, this adverse shock is likely to persist for a while, and the necessary reallocations will take time to complete. Indeed, the economy’s potential output may be lower than previously estimated for some time. This means measures of the so-called output gap, the difference between the level of actual and potential output, will not be as high as they otherwise would be and may be volatile and hard to measure, especially since potential output is inherently unobservable. This is an important point to which I will return shortly.

Hmm. So he says potential output is now going to be much lower than what it was previously.

It makes sense actually though doubt whether the growth rates can still catch up. As pointed out earlier, Japan’s lost decade (if I may call so) was because of fall in productivity. Another way to say is that the potential output had fallen.  However, despite the fall, the growth rates did not pick up because the loss in productivity was quite severe. Even in the case of US, the same logic can apply. Though, potential output might have declined (as much was because of financial services anyways), we don’t know whether growth rates can actually increase to catch up even with the fallen output.

Further he says:

My view of the economic outlook is also shaped in part by a forecasting model we are developing at the Philadelphia Fed. This model is based on what has become the workhorse model of modern macroeconomics. One of its key features is that expectations of future economic variables are forward-looking. Interestingly, this type of model produces a forecast that shows a significant recovery underway by the end of the year.

While I see somewhat more economic growth over the next 12 to 18 months than some private-sector forecasters, I also see less deflationary pressure in the near term than other forecasters, such as those in our latest Survey of Professional Forecasters. And I see greater risk of higher inflation over the intermediate to longer term.

He also provides link to the paper which explains the macroeconomic model. Not surprisingly, it uses the DSGE model (see my paper for an overviewas well)  which has been at centre of criticism lately. I have never really used DSGE model (nor have the capability) but from whatever I read it ignores many of the problems we have in the economy. For instance, it hardly puts enough weightage on financial market frictions and assume markets to be efficient etc.  We all know it is anything but true. I don’t know whether this model has made any changes.

Another point is forward looking nature of the model. Now in this crisis, we know one of the main issues was lack of historical data. As a result, much of the models used were forward looking with assumptions like housing prices will continue to rise, housing market prices will not fall across the country etc etc. I am wondering how forward looking models can be developed? Can we really peek into future for the entire economic framework? I have my doubts.

Anyways, nice point about potential output.

Is Fed purchase of Treasuries working?

May 26, 2009

Daniel Thornton of St Louis Fed in a research note says:

Chairman Bernanke seems to suggest that the purchase of a large quantity of longer-term government securities might reduce longer-term rates. With short-term rates already near zero, this would cause the yield curve to flatten, as long-term rates decline relative to short-term rates.

But there is a catch to the idea:

However, the idea that the Fed can influence long-term interest rates by intervening directly in the longer end of the market is inconsistent with the commonly held view—that is, the expectations hypothesis. This hypothesis assumes that there is a very high degree of substitutability (essentially perfect) among Treasuries of various maturities. Under perfect substitutability, the reduction in long-term rates (with unchanged risk premiums) would cause investors to purchase the lower-yielding short-term assets and sell the now higher-yielding long-term assets.

This arbitrage activity could cause longer-term rates to rise and short-term rates to fall. This process would continue until the yield curve returned to its previous structure. The only possible effect of the increased purchase of long-term securities would be on the position of the yield curve: It could shift down if the purchase of long-term Treasuries sufficiently increased the supply of credit relative to demand.

He then analyses the recent data with the Fed announcement and finds that the expectations hypothesis is working! The announcement led to easing of yields at long-term initially but then the hypothesis started working. This led short-term yields to ease and long-term yields to harden, steepening the curve.

However, it is difficult to say if the steepening is mainly due to the expectations hypothesis:

There have been many events that markets have responded to since March 18. Hence, it is difficult if not impossible to attribute the steepening of the yield curve to a particular factor. The Fed has increased its purchases of longer-term Treasuries and expanded its balance sheet by about $150 billion since March 18. Whatever their immediate effect, these actions appear to have had no permanent effect on the yield curve.

Great insights.

Risk Management for Central banks

May 26, 2009

Dr Subba Rao, Governor of RBI in his recent speech gives a risk management perspective to the current Central Bank problems.

He first summarises the global economy developments and policy responses and then looks at Indian economy and policy responses. As the conference where he speaks is on risk management he says:

So, where and how does the economic dilemma fit into the topic of risk management, which is the subject of this summit? It fits in because the context throws up questions about risk management in the macroeconomy.  How does one hedge against the uncertainty of outcomes of toady’s fiscal and monetary policy actions? How does one insure against such risks? Clearly there are no easy ways; if indeed there were, we would not be having this seminar. I will focus on three aspects: monetary policy, fiscal policy, and financial stability to define the contours of uncertainty.

Monetary Policy

On the monetary policy front, managing the risk calls for maintaining ample liquidity in the system. The RBI has done so the past six months through a variety of instruments and facilities.  And in the April 2009 policy review, we extended the tenure many of these facilities. Some will argue, and rightly so, that this might be sowing the seeds of the next inflationary cycle. And this is exactly the kind of risk one has to grapple with. So while the Reserve Bank will continue to support liquidity in the economy, it will have to ensure that as economic growth gathers momentum, the excess liquidity is rolled back in an orderly manner. 

Fiscal Policy

The challenge for fiscal policy is to balance immediate support for the economy with the need to get back on track on the medium-term fiscal consolidation process.  The fiscal stimulus packages and other measures have led to sharp increase in the revenue and fiscal deficits which, in the face of slowing private investment, have cushioned the pace of economic activity.

Financial Stability

Beyond monetary and fiscal policies, preserving financial stability is key to navigating these uncertain times.  A sound and resilient banking sector, well-functioning financial markets, robust liquidity management and payment and settlement infrastructure are the pre-requisites for financial stability.   The banking sector in India is sound, adequately capitalized and well-regulated.  By all counts, Indian financial markets are capable of withstanding the global shock, perhaps somewhat bruised but definitely not battered.

Well all this is pretty well known. The risk management perspective to the entire set of issues is interesting.

Ten Swedish Lessons for India’s Budget Consolidation Program

May 25, 2009

I had earlier pointed out to a paper on how Indian policymakers should approach Budgetary Reforms.

I came across another excellent paper from Jens Henriksson. He saw the Sweden’s Budget Restructuring program pretty closely. He offers ten invaluable lessons for all policymakers attempting to reform budgets.

  1. Sound public finances are a prerequisite for growth
  2. If you are in debt, you are not free
  3. The one responsible must her or his job on the line
  4. Set goals and stick to them
  5. Consolidation shpuld be designed as a package
  6. Act structurally but be consistent
  7. Do not leave the problems to local authorities
  8. Be honest to citizens and financial markets
  9. Stick to one message
  10. Stick to it

In the author’s words:

If I were to sum up the lessons I have learned it would be the following: The two first lessons were about why I think it is important to get your public finances in order. Lesson three and four was on different ways on how to signal commitment, that you really intend to do something about the deficit. Lesson five, six and seven were on the nuts and bolts of a consolidation programme. Lesson eight and nine was on how to communicate while the programme is running. And the tenth and final lesson was how to avoid getting back in trouble.

All the lessons have excellent anecdotes and valuable insights to think about budget reform.

By the way why Sweden? Sweden faced a huge debt problem after the crisis in 1992.


In its Economic Outlook of December 1994 the OECD projected that the Swedish public debt would explode. By the year 2000 the public debt was expected to hit a record 128 percent of GDP debt for 2000. Today we know that the gross turned out to be less than half that figure at 53 percent. And within a few years the budget deficit, from a high of over 11 percent of GDP, turned into a large surplus.


But getting there was not an easy task. During the consolidation of public finances, I had the opportunity to work in close contact with different ministers of finance in Sweden. This paper relates what this experience taught me about the political economics of budget consolidation.


 It is not a paper about how to get rid of the welfare state. On the contrary, it is about how to strengthen the economic foundations for whatever kind of social model that is preferred. The budget consolidation in Sweden was dramatic but it preserved, and in many ways modernised and improved, the welfare system.

The emphasis is on transparency and stuicking to the plans. This was also the lesson Swedish policymakers learnt (and tried to teach) during the 1992 Banking crisis as well..

A wonderful read.

Keeping track of rising protectionism in world trade

May 22, 2009

Chad Brown of Brandeis Universitykeeps a tab on what is happening in World Trade System. His research on the issue looks quite promising as well.

He has develoepd a seperate webpagefor keeping a track on how world trade system is faring in this crisis? Is protectionism rising? If yes which countries are raising trade barriers and against which countries?

He says in both 2008 and Q1 2009, protectionism is on a rise. India seems to be the leader in both the periods initiating cases and imposing trade restrictions.

In 2008:

  • Overall, the number of initiations of new anti-dumping investigations in 2008 increased by 31 per cent compared to 2007. The number of new anti-dumping measures applied in 2008 increased by 19 per cent compared to 2007. Developing countries dominated use of anti-dumping (73% of all new investigations) in 2008, and developing country exporters were the most frequent target (78% of all new investigations).
  • Sixteen WTO Members initiated a total of 188 new antidumping investigations in 2008, compared with 143 initiations by the same Members in 2007.[3]These Members applied 120 new final anti dumping measures in 2008, a 20 percent increase over the 100 new measures that these Members applied in 2007
  • India initiated the most antidumping investigations in 2008, with 54 new initiations.[5] It was followed by Turkey and Brazil (23 each), Argentina (19), the United States and the European Union (18 each), China (7), Colombia and Australia (6 each), South Korea (5), and Canada, Pakistan, and South Africa (3 each).
  • Exporters in developing countries were the subject of 147 antidumping investigations in 2008 – forty-five per cent more than the 101 investigations directed at developing country exporters in 2007. In addition, 92 of the 120 new measures in 2008 were applied to developing countries′ exported products, compared with 78 of 100 new measures in 2007. China was the most frequent subject of antidumping investigations in 2008, as thirty-five per cent (66 initiations) of all the new initiations in 2008 were directed at its exports.

It was pretty obvious that China would lead the list of countries against whom the barriers would be raised. Surprising to see India top the list in countries raising these barriers. You would usually assume developed economies to impose barriers on China.

In Q1 2009:

The first quarter 2009 increase is above and beyond the sharp increase that began in 2008 with the spread of the global economic crisis. Compared to the same time period in 2008, the first quarter of 2009 saw an 18.8% increase in initiated investigations in which domestic industries request the imposition of new import restrictions under trade remedy laws. While the list of new investigations is dominated by India and Argentina, other G-20 members that also initiated at least one new investigation during the first quarter of 2009 include Australia, Canada, China, the European Union and its member states, Mexico, South Africa, Turkey and the United States. China`s exporters were the dominant target for these new investigations that may result in import restrictions, facing over two thirds of the new investigations.

Excellent work from Prof Brown. You get an idea on world trade in this crisis in one page. The protectionism is clearly rising and WTO has huge task at hand.

A look at Australia’s Inflation Targeting Framework

May 22, 2009

Guy Debelle of Reserve Bank of Australia (RBA) has given an interesting speech on ITF in Australia and compares  it with UK.

The history of RBA adopting ITF is quite interesting:


Why impact on Latin America has been muted in this crisis?

May 21, 2009

Jaime Caruana, General Manager of the BIS has given an insightful speechon the big question- How and Why the global crisis did not effect Latin America as much? They usually have been affected severely in the past irrespective of the origin of the crisis.

Caruana looks at the region as a whole and not individual economies. The main reason was limiting currency mismanagement in balance sheets of banks and other firms. This was achieved by three painful adjustments:

a) the adoption of flexible exchange rates combined with higher levels of forex reserves;
(b) the development of local currency bond markets; and
(c) strong regulation of the liquidity of banks’ foreign currency positions.

The speech is a great read with numerous graphs and tables. It reviews the role of international banks in the region and main concern seems to be coming from them.  

Originate to distribute model – distributed fear rather than risks

May 21, 2009

Alex Weber, President of Bundesbank in his recent speech says:

It has now become clear that the “originate and distribute” model can actually improve the resilience of the financial system if, and only if, a high-quality standard is maintained at all levels of the transfer process, and no new concentrations of risk arise. Since the outbreak of the financial crisis, however, we have learned about a series of distorted incentives, which manifested themselves in lax origination standards for products such as subprime mortgages and in some investors’ excessive reliance on credit ratings. In the end, securitisation, as Claudio Borio from the BIS aptly put it in 2008, has, ultimately, “distributed fear rather than risks”

🙂 He also touches on the initiatives taken in Germany and issues for monetary policymakers:

In my view, monetary policymakers should not view boom and bust episodes on the financial markets as unrelated events. Monetary policymakers’ responses to upturns as well as to downturns on the asset markets influence the risk perception of the market participants. Therefore, an (expansionary) monetary policy response which is stronger in the downswing than the (restrictive) response in the upswing creates adverse incentives for investors which could increase the amplitudes of the financial cycle.

A more symmetric approach by monetary policymakers would treat boom and bust episodes not as isolated events but would try to look through the financial cycle in order to steady policy. To be more specific, a more symmetric policy would also consider implicit risks in times when money and credit growth is dynamic, asset prices go up and risk perceptions decline, possibly weighing the need to act despite low current consumer price inflation rates.

This, however, does not mean that monetary policy should downgrade the price stability objective for the sake of other objectives. Indeed, financial crises heighten the volatility of macroeconomic variables such as inflation and growth. Rather, it means that central banks should take a longer-term perspective which takes into account the future inflationary consequences of such unfavourable developments. Given the macroeconomic relevance of financial crises, we have good reason to enlarge our monetary policy time horizon and give low-frequency movements in credit and monetary aggregates more weight in our analytical frameworks and our monetary policy decision-making processes.

Being from Bundesbank, a push for using monetary aggregates is obvious and timely.

OTC Derivative Markets- Notional Amount declines but Market Values increase

May 21, 2009

As US Treasury looks to regulate OTC derivative markets BIS released its new report on the size of the market. The data comes with a lag and we have data till Dec 2008.

The press release provides quick findings:

  • The total notional amount of over-the-counter (OTC) derivatives contracts outstanding was $592.0 trillion at the end of December 2008, 13.4% lower than six months earlier. The decline is the first since collection of the data began in 1998
  • Credit market turmoil and the multilateral netting of contracts led to a contraction of 26.9% in outstanding credit default swaps (CDS). The second half of 2008 also saw the first significant decline of OTC derivatives contracts outstanding in the interest rate market (8.6%) and in the foreign exchange market (21%
  • Despite the drop in amounts outstanding, movements of financial market prices in the second half of 2008 lifted gross market values 66.5%, to $33.9 trillion. Gross market values measure the cost of replacing all existing contracts and are thus a better measure of market risk than notional amounts outstanding.

BIS releases these stats bi-annually and it is just amazing to think we have created a multi trillion dollar market without anyone watching the growth. Just amazing. It clearly speaks of the mindset w.r.t. to financial world.

The Wall Street Culture that led to crash

May 21, 2009

It is always refreshing to read speeches of John Bogle (available on his blog). He has been questioning the practices in the financial sector for a very long time. His name should also feature in the names of all those people who predicted this crisis. His idea has always been that the people in the financial industry have forgotten that they need to serve the people and instead are just working for themselves. As he is from Vanguard, his severe criticism is always targeted at Mutual Funds.

I was reading his recent speech where he once again raises the same issues:

Relying on Adam Smith’s “invisible hand,” through which our own self-interest is said to advance the interests of our communities, our society had come to rely less on strict regulation to govern conduct in the field of free enterprise—in commerce, business, and finance—and to rely more on open competition and free markets to create prosperity and well-being, and to add value to our society.

But that self-interest got out of hand, and it spread to the very core of our national culture. Simply put, we became what has been called a “bottom line” society, one in which progress and success are largely measured in monetary terms. But our society, I think, is measuring the wrong bottom line: not only money over achievement, but form over substance; prestige over virtue; charisma over character; the ephemeral over the enduring; even mammon over God. Dollars have become the coin of the new realm, and unchecked market forces totally overwhelmed traditional standards of professional conduct, developed over centuries.

He quotes speeches from some people really long ago who had commented on the same issues which are bothering us right now. Why were the warning ignored? Perhaps Simon Johnson comes closest to explaining the events.

He says the society has moved from being an ownership society to agency society where managers have become more powerful than the owners, Speculation has gained wisdom over investments and how mutual funds continue to milk investors by charging high expenses. Here are some points on MF industry:

Example: the average expense ratio of the ten largest funds of 1960 rose from 0.51 percent to 0.96 percent in 2008, an increase of 88 percent. (Wellington Fund was the only fund whose expense ratio declined. Excluding Wellington, the increase was 104 percent.)

Three of the largest advisers, for example, charge an average fee rate of 0.08 percent of assets to their pension clients and 0.61 percent to their funds, resulting in annual fees of just $600,000 for the pension fund and $56 million for the comparable mutual fund

Vanguard’s lowcosts are legendary, by far the lowest in the field. Last year, over all, our operating expense ratio came to 0.20 percent of average assets, compared to 1.30 percent for the average mutual fund. That 1.1 percentage point saving, applied to one trillion of assets, now gives our shareholders an average savings of $11 billion annually. Do low costs matter? Of course they do! As the world of investing is at last beginning to understand, low costs are the single most reliable indicator of superior fund performance.

Shocking numbers really.

I just calculated the average expense ratio of all diversified equity funds in India and it is 2.14%. I am wondering whether the expense ratios have fallen or declined over the years. Looking at the way MF managers are paid in India (see this as well)  it should only be rising. Moreover, we hardly have any discussion in India over MF expenses. There is hardly any reporting of returns after netting expenses. There is hardly any advertisement for passive funds/index funds. The tracking error of index funds I am told is quite high which also is not understood. It is much better to be distributor of the funds (see this as well) or be an institutional investor.

We need someone like Bogle to help us know more  about India’s MF industry.

Riksbank awarded for using simple language

May 20, 2009

Riksbank (Sweden Central Bank) has been been given an unusual award. One does not really expect a central bank to get award for using plain and simple language to explain their decisions. 

The Riksbank has been awarded the Language Council’s Plain Swedish Crystal for its work on making the Monetary Policy Report and Financial Stability Report comprehensible to members of the general public who are interested in reading them. The Riksbank is also awarded the prize because its work on using plain language is driven in a long-term and sustainable manner and has been integrated into the Bank’s daily work.

Riksbank explains the effort behind the award:

To formulate our message in plain language and in a way that all target groups can understand. This was the Riksbank’s objective when the Plain Swedish project was started up in 2007. After two years’ work on editing texts, providing language coaching for those who write a lot of texts and organising seminars on plain language, we are now reaping the rewards. The language in our speeches, press releases and reports has become more readily understandable and the structure has become clearer. 

A project by Central bank to simplify communications! Not bad at all. This is something all Central Banks should emulate.

It has been quite a change from the Greenspan days which all central bankers followed. His famous quote:

I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.

Great going Riksbank. Actually it has been a pioneer many a times.  It was the first Central bank in the world, it was quite uccessful in price level targeting, set high standards as an inflation targeting central bank and now this award for using plain language. All Central Banks should take note of this development.

Decline in Productivity key to Japan’s lost decade?

May 20, 2009

Whatever research I have read on Japan’s lost decade  I always thought the reason for crisis was – asset market boom (with rising real estate and equity prices), banks lending to the real estate companies and other zombie corporations. Once the house prices fell, all things collapsed. We are seeing the same events in US and other economies whose fin firms were linked to US housing markets. That is why we often compare the 2 events. And then the policy moves deepened the recession (though Japanese policymakers don’t agree, see this as well)

In my quest to find anything on Japanese, I came across this paper from Edward Prescott and Fumio Hayashi. Here is what they say:


Thinking about India’s Budgetary Reform

May 19, 2009

India’s rising fiscal deficit and the need to reform it, is being seen as the top priority by economists and business media.  The question is how do we think about reforming budgetary institutions?

Richard Allen of IMF has written a sitimulating paper on reforming budgetary institutions and challenges the process of reforms brings. Here is a blog post by the author as well.

The paper notes that the development of sound budgetary institutions in countries such as France, the U.K. and the U.S. has taken a very long time ―200 years or more―and is still evolving. It discusses Douglass North’s prediction ―which is supported by available data ―that institutional reform is also likely to be very slow in developing countries since the budget is especially prone to rent-seeking influences. Finally, the paper discusses the currently fashionable emphasis on complex, multiannual PFM reform strategies, which have been strongly promoted by the donor community; and advocates a simpler approach grounded on Schick’s important principle of “getting the basics right.” The paper identifies several areas where further research would be fruitful.

It is a very useful paper and also provides a lit survey on the key issues on public debt management. It discusses the various frameworks by which one can reform the public debt institutions. Here is one para I liked which sums the dilemma for developing countries pretty well:

Finance ministers have an important potential role in coordinating and driving improvements in the budget process; indeed, without their intervention and active leadership, such improvements are unlikely to take place. Unfortunately, in most developing countries, they do not enjoy the powerful status they have in the developed world. Indeed, the national plan (or poverty reduction strategy) is often regarded as the preeminent policy document for planning the allocation of national resources and for attracting donor financing. The division of responsibility for the budget between capital investment projects (managed by the minister of economy) and recurrent expenditures (minister of finance)—another common practice in developing countries—not only fragments the budget process, but significantly weakens the role of the finance minister as a potential leader of the reform process.

One cannot really wish away the other development programs needed in emerging and underdeveloped economies. The question is how do we balance them.

In India’ case also economists are divided over the fiscal deficit. Though a vast majority feels we need to rein in fiscal deficit, there are some in minority that say it should not be at the cost of these development programs. They add the distribution of these programs may not be efficient but then it is a different debate/issue. Now, as these development programs are usually public goods the government has to step in. If its steps in the fiscal deficit rises/remains high. Tough choices really and as usual we don’t really have answers.

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