Archive for January, 2010

Economics stands for….

January 30, 2010

Greg Mankiw points to an email he has received from an economics professor Gordon Boronow. Boronowhas created an acrostic device to remember what economics stands for. He adds exclaimation marks at the end. Here it goes:

Ten Key Principles in Economics

Everything has a cost. There is no free lunch. There is always a trade-off.

Cost is what you give up to get something. In particular, opportunity cost is cost of the tradeoff.

One More. Rational people make decisions on the basis of the cost of one more unit (of consumption, of investment, of labor hour, etc.).

iNcentives work. People respond to incentives.

Open for trade. Trade can make all parties better off.

Markets Rock! Usually, markets are the best way to allocate scarce resources between producers and consumers.

Intervention in free markets is sometimes needed. (But watch out for the law of unintended effects!)

Concentrate on productivity. A country’s standard of living depends on how productive its economy is.

Sloshing in money leads to higher prices. Inflation is caused by excessive money supply.

!! Caution: In the short run, falling prices may lead to unemployment, and rising employment may lead to inflation.

Amazing this….Thanks Prof. Boronow.

Why europe based economists prefer to study/work in US?

January 30, 2010

Guy Sorman has written a nice article on Europe based economists (HT: MR and Economix).  It discusses why large number of Europe based economists moves to US to study and prefer to stay in US after their studies as well.

Some facts:

One-third of the faculty of Harvard University’s economics department hails from Europe. At the University of Chicago’s Booth School of Business, half of the finance department’s faculty is European. And these schools aren’t alone: European economists are overrepresented at all first-tier American universities and have had a huge influence on economic thinking, doing cutting-edge research in areas ranging from modeling financial markets to assessing risk.

Why?

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Importance of institutional design for monetary policy

January 30, 2010

Mervyn King gave a speech in 2004 on importance of institutions of monetary policy.

I argue that it is useful to think about the optimal design of monetary institutions using the insights  from the theory of incomplete contracts. The core of the monetary policy  problem is the uncertainty about future social decisions resulting from the successors to any given monetary policy strategy. The impossibility stems from the observation that collective decisions cannot be enforced so that it is impossible to commit to future collective decisions. The undesirability reflects the fact that we cannot articulate all possible future states of the world.

Monetary institutions expand the possibility frontier of the technology of collective decisions by raising the costs of making inefficient deviations from pre-announced paths. I illustrate the importance of institutional design for the operation of monetary policy by reference to three case studies: the collapse of exchange rate regimes in Brazil and the United Kingdom; currency arrangements in Iraq and their reform after the 2003 war; and the relationship between central banks and governments when the zero constraint on nominal interest rates is binding.

Very interesting case studies. Especially of currency arrangements in Iraq. There were 2 currencies in Iraq in 1991 – one known as Swiss Dinar in North Iraq and Saddam Dinar in South Iraq. Saddam Dinar was backed by government but not Swiss and still remained a currency! How the two move because of changes in political regime is fascinating stuff.

However, for current times the 3rd case study is more appropriate. King says:

The interplay between monetary policy and debt management may not matter too much when short-term interest rates are positive because the central bank can control the level of interest rates, even if debt management affects the optimal level of rates. But when rates are at their zero bound then the central bank no longer has instrument independence. Indeed, because its actions can be offset by appropriate sales or purchases in the government debt market, it loses goal independence too. It becomes crucial that fiscal and monetary authorities cooperate.

Interesting again. I never thought it this way. In ZIRP, central bank loses both instrument independence (as rates are zero) and goal independence (what goals as finance ministry/treasury  rules!).  Read the case study of Japan in this context.

Politics of selecting ECB president

January 29, 2010

It is great fun to be reading eurointelligence daily editions these days. It usually has one news item on politics of selecting ECB’s next Vice – President and President. VP’s terms gets over in July 2010 and President’s in October 2010.

On the same website, Francesco Giavazzi of Bocconi University has a nice article behind the drama titled nicely as How not to select the ECB President.

Once again the procedure the Eurogroup is following in designating new members of the Governing Council of the European Central Bank is unlikely to select the candidates best suited for the job. This time, however, the damage could be more serious: on February 15 the Eurogroup—because of the way it decides–will de facto select two candidates, the vice-president and the President.

Deciding on the new President so long ahead of time (the formal decision will only be taken by the European Heads of State in the Spring of 2011) is clearly against the Treaty. This, however, is what will happen if the Eurogroup accepts to follow the Brussels practice of assigning jobs based a the size and geography of countries: one from a big one, the other from a small one, one from the North, one from the South. The only difference this time is that gender will not be a parameter in the decision—it has in the past. This is why, on February 15, the vote on the new vice-President might become a proxy vote for the new President. If the vice President will come from a southern European small country the President – some will contend – should come from a large country in the North—guess which. If instead he will be a national of, say, the Benelux, the President should come from a large country in the South.

🙂 This is just typical Europe for you.

He then points what the ECB treaty says:

Let us remind ourselves what the European Treaties say (Protocol 18 on the Statute of the European System of Central Banks and of the ECB, article 11.2): “The President and the vice President, and the other members of the Executive Board, shall be appointed from among persons of recognized standing and professional experience in monetary and banking matters.” No mention is made of nationality.

He points to 4 questions that Euro area  politicians should be looking at:

Rather than working around a geographical map of the Euro area these the four questions that should inform its decision:

1) modern monetary policy is about effective communication. Communicating is particularly difficult in the Euro area, as it requires a President able to reach out to over 300 million citizens, recognizing their diverse cultures and without moving markets. Who could best match the talent of Jean Claude Trichet at doing this?

2) the crisis has put a premium on financial experience, both direct experience in financial markets and institutional experience in designing financial regulation. Which candidate comes on top on financial market experience?

3) one of the President’s most important tasks is steering the Governing Council, a group that by now is very large and risks becoming ineffective. Who could match the talent of Jean Claude Trichet?

4) if the Eurogroup was worried about the candidates independence, not only from domestic political pressure but also from the pressure that some national ailing banking systems may put to unduly prolonge central banking support, which personality has proved more independent? With an important, and still very weak, fraction of the German banking industry controlled by local politicians, would it be wise to select a President who is a German national?

Nicely said but it is just too difficult to ignore politics and nationality issues while selecting for ECB. They will continue till the final decision is made.

Interviews to read

January 29, 2010

There are some interesting interviews:

 I have been pointing to a lot of interviews. In case you have missed here are a few:

Interview fest….

RBI Third Quarter 2009-10 review – just 10 pages

January 29, 2010

I had posted on how RBI Governor Mr Subbarao is ushering in more transparency at the central bank.

His recent monetary policy statement for Q3 2009-10 is just 10 pages long (or short). It shows 13 pages but first two pages have nothing in it and last page is blank. It is a big improvement from the 40-50 pages statement which came earlier.

However, the statement should be read with macroeconomic and monetary developments report released yesterday. It is around 90 pages long which could be cut short as well. The Macroeconomic and Monetary Developments report is released a day before the monetary policy report. But we hardly get regular economic analysis from RBI, so some might say it is ok to have a detailed analysis quarterly.  

Earlier Governor’s monetary policy statements repeated most of the analysis in macroeconomic and monetary developments report. Now the statement simply says:

This Policy Review statement should be read and understood together with the detailed review in Macroeconomic and Monetary Developments released yesterday by the Reserve Bank.

 Welcome change. Helps job of economists/analysts so much. It is also environment friendly.

St Louis Fed’s Financial Stress Index

January 28, 2010

Kevin L. Kliesen and Douglas C. Smith of St Louis Fed inform about a new tool they have developed to measure financial stability.

There are many ways to measure financial market stress. One is to look at an interest rate spread designed to measure default risk, such as the difference between yields on a “risky” asset (e.g., corporate bonds) and a “risk-free” asset (e.g., U.S. Treasury securities). However, financial stress can also arise in other dimensions. One type of risk prominent in the recent financial crisis was the inability of many financial institutions to secure funding to finance their short-term liabilities, such as repurchase agreements (repos). This type of risk is known as “liquidity risk.”

To overcome a potential problem of focusing solely on one indicator at the expense of others, some economists have combined several indicators designed to measure financial market stress into one summary variable, like an index number. A recent example of such an index is the Kansas City Financial Stress Index (KCFSI), measure constructed by the Federal Reserve Bank of Kansas City that uses 11 financial market variables. However, one potential limitation of the KCFSI is its use of monthly data. Significant developments in the financial markets often occur much more frequently (e.g., the difficulties associated with Bear Stearns and Lehman Brothers), so a more “realtime” index might be better. The trade-off for a higher frequency index, of course, is greater volatility, and thus, perhaps, noise.

For a more detailed description of the index see this. Those interested in fin stability measures should check out this survey I pointed earlier.

The authors then test the FSI on 3 key events – Russian Debt default in 1998, BNP Paribas suspending redemptions from hedge funds in 2007 and Lehman bankruptcy in 2008. They find the index showed alleviation of financial risks in the system in each of the three.

However, the authors add that the index is better seen as a coincident indicator and not a leading one.

in each instance, the STLFSI seemed to accurately capture the subsequent turmoil and financial stress. In one sense, the STLFSI and the KCFSI can be thought of as coincident indexes rather than as leading indexes—that is, they are designed to measure developments as they occur. In another sense, however, they have leading indicator properties because rising levels of financial stress, as recently seen, can portend economic turmoil and disruption.

A nice short read.

Free e-Book on Behavioral Economics

January 28, 2010

Boston Fed held a conference in 2007 on beh eco and policymaking. It has compiled the papers and discussions as an e-book.

Happy reading.

ECB’s relation with EU institutions and bodies

January 27, 2010

ECB monthly bulletin has this piece  on ECB relations with various EU institutions.

It starts off well, but becomes too confused towards the end. There are just too many EU institutions. Here is a sample:

  • European Parliament
  • Ecofin Council
  • Eurogroup
  • Econ0mic and Financial Committee
  • Economic Policy Committee
  • European Commission
  • European Council and EU council

Phew… Managing ECB is such a task.

Anyways, a nice look into various EU based institutions.

Primer on Interest on Bank Reserves

January 27, 2010

While talking on measures to exit from Fed’s easy policies, Bernanke suggests (followed by others) interest on reserves as one of the ways.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

For those who wonder what this is, here is a nice primer by Richmond Fed economist John Walter on the concept. Explains nicely.

Evolution of central banking in India

January 27, 2010

An insightful speech by Rakesh Mohan on the topic. He begins looking at evolution of central banking from a global perspective:

Evolution of central banking is essentially a twentieth century phenomenon as there were only about a dozen central banks in the world at the turn of the twentieth century. In contrast, at present, there are nearly 160 central banks. This is not surprising since the need for central banks obviously emerged as banking became more complex, while becoming an increasingly important part of the economy over time. The many vicissitudes experienced by banks and their depositors inevitably led to cries for their regulation. Second, central banks are essentially a nation state phenomenon, and hence proliferated as nation states themselves emerged and multiplied: again a twentieth century phenomenon. Third, it is useful to recall some of the reasons for the origin of central banks: to issue currency; to be a banker and lender to the government: to regulate and supervise the banks and financial entities: and to serve as a lender of- last-resort.

This is ironic since much of the current professional thinking is that a central bank should be independent of government, should no longer be a debt manager of the government, and should not regulate or supervise commercial banks. The new objective function assigned to the central bank is to focus on This is perhaps not surprising since price stability was historically achieved, along with preservation of currency value, through the gold standard, and  later through the dollar anchor and its relation to gold. The world lost its monetary anchor on August 15, 1971 when the US decided to delink the dollar from gold, and has been floundering ever since in search of a new anchor.

After the convulsions of the 1960s and 1970s, mainly related to the financing of the Vietnam war, the expansion of world liquidity, and the ensuing somewhat enduring inflation, along with Latin American fiscal and monetary expansion, the new holy grail is independence of the central bank, a concept that is becoming almost synonymous with inflation targeting. And here, though I am too new to central banking to really offer a definitive view, I have to admit to a certain skepticism related to the current fashion among central bankers.

Two pertinent questions are natural to be asked. First, why is it so obvious that central banks should abandon their ‘parents’, the sovereign government? One quick explanation could be that the central banks have ‘come-of-age’ in recent years. But then, some instances like the case of two currencies in Iraq in the 1990s and that of the Bank of Japan in recent years provide a contrary view to the ‘come-of-age’ hypothesis (King, 2004). Second, is it really the case that supervision and regulation of banks by the central bank leads to conflict of interest? In consideration of this conflict, the Financial Services Authority was established in the UK in 2000, and a number of countries have followed suit. What I would like to do today is to explore some of these issues as they relate to India at the present time.

He then looks at how RBI came into being. The central point he makes is though RBI is a central bank responsible for monetary policy, RBI has played a much wider role in development of Indian economy. This is because of both, Indian economic situation (high poverty, large rural population, high poverty etc) and lack of proper institutional framework which made RBI do bulk of economic development.

Read the whole thing.

WTO establishes chairs at 14 developing country universities

January 27, 2010

WTO had established Chairs Program in 2009:

The main objectives of the Programme, which was launched in March 2009, are to:

  • build lasting relationships with institutions from developing and developed countries by according financial support to beneficiary institutions for four years
  • support trade-related teaching by providing WTO support for the development and delivery of courses on trade policy and WTO-related matters in academic institutions.
  • foster further research in trade-related matters and highlight the policy relevance of existing research — universities awarded the Chairs are expected to cooperate with other institutions in the Programme, through joint research, shared lecturing arrangements and student/academic exchanges  
  • encourage and extend outreach/communication — universities awarded the WTO Chairs are expected to organize public activities aimed at disseminating research and promoting discussion regarding international trade and trade cooperation.

The program would be awarded to 14 universities.

WTO released the list of 14 universities which have been selected for the program. I don’t know whether any Indian University applied, but there is no Indian univ name in the list.

WTO recently awarded 2 young researchers for research work.  Nice initiatives from WTO to bring more research work on trade. 

Blaming Chicago Economists for the crisis?

January 27, 2010

There has been a lot of criticism of Chicago University and its free market ideas. John Cassidy does interviews of quite a few Chicago Economists and gets diverse views.

John Taylor turns the blame on its head in his new blogpost. He says all these views are subjective. Is there a more objective way to blame Chicago econs?

Consider, for example, measuring influence by the representation of members of a school in top economic positions in government where there is an opportunity to influence policy. And consider as a measure of an economist’s school, the university where he or she received the PhD. The data in the chart follows this approach. It shows the university PhD percentages of appointees to the President’s Council of Economics Advisers (CEA).

The blue line shows the percentage of presidential appointees to the CEA who have a PhD from Chicago. The red line shows the same for MIT or Harvard (Cambridge), one possible definition of an alternative to the Chicago school. The years from the creation of the CEA in 1946 until 1980 are shown along with each presidential term thereafter. Observe that the peak of the Chicago school influence was in the Reagan administration; it then dropped off markedly. In contrast Cambridge reached a low point of zero appointees to the CEA during the Reagan administration and then rose slightly to 20 percent in Bush 41, to 82 percent in Clinton, and to 100 percent in both Bush 43 and in Obama.

Blaming the financial crisis on the free-market influence of the Chicago school is certainly not consistent with these data. There were no Chicago PhDs on the President’s CEA leading up to or during the financial crisis. In contrast there was a great influx and then dominance of PhDs from Cambridge. And also notice that there were plenty of Chicago PhDs on the CEA at the time of the start of the Great Moderation—20 plus years of excellent economic performance. These data are more consistent with the view that the waning of the free-market Chicago school and the rise of interventionist alternatives was largely responsible for the crisis. But the main point is that there is no evidence here for blaming the influence of Chicago.

Of course, such measures are imperfect. Neither Milton Friedman nor Paul Samuelson served on the CEA, but their students did. And while PhDs from any insitution certainly do not fit in any one mold, the people who learned about rules versus discretion with Friedman likely had a different policy approach than people who learned about rules versus discretion with Samuelson. The data are robust when you look beyond the CEA to other top posts normally held by PhD economists. All assistant secretaries of Treasury for Economic Policy appointed during the Bush 43 and Obama Administrations had PhDs from Harvard. During the same period, all chief economists appointed to the IMF had PhDs from MIT, and, except for Don Kohn, who was promoted from within and Susan Bies who was appointed as a banker, all PhD economists appointed to the Federal Reserve Board were from Cambridge MA.

The war is far from over!!

Shadow Banking issues

January 25, 2010

Paul Tucker of Bank of England has been taking the issue of financial stability with seriousness. He ahs been speaking on various issues in the past. In this speech, he looks at shadow banking.

He first looks at various kinds of shadow banks/systems developed before this crisis – money market mutual funds; finance companies; Structured Investment Vehicles and Asset Backed Commercial Paper; the prime brokerage services of securities dealers; the use of securities lending as a financing market; and the repo-financing of mortgage-backed securities.

He says we need to bring them in the regulatory ambit and keep looking out for regulatory arbitrage:

For those forms of financial intermediation that are dependent on banks for leverage and liquidity, it may be that we can develop macroprudential instruments that could be deployed to restrain excess by influencing banks’ supply of credit to them. That is another major area of work.

But where a form of shadow banking provides an alternative home for liquid savings, offering de facto deposit and monetary services, then I think we should be ready to bring them into the banking world itself. In the latest episode, constant-Net Asset Value, instant-access money funds and the prime brokerage units of the dealers seem to have been examples of that.

We have not seen the last of regulatory arbitrage. So we need policies and principles that stand in the way of its weakening the resilience of the system, while allowing enterprise and our capital markets to flourish.

An insightful look into the world of shadow banking.

Where did Obama’s Bank Tax/Fee plan come from…from Sweden

January 25, 2010

Yeah, it came from Sweden. NY Times has an article (HT: The Big Picture Blog) explaining the details.

When it comes to rescuing banks, the Swedes are earning a reputation as trendsetters. First they set a standard for recovering from disaster; now they want to export their idea for how to pay for it.

The country went through its own crippling banking crisis during the early 1990s, after the bursting of a domestic credit bubble. It rebounded relatively smoothly through an aggressive bailout policy built around nationalization and carving the troubled assets of banks off into a so-called bad bank.

That blueprint was followed to varying degrees over the last year or so in the United States, Japan, Britain, the Netherlands and other countries.

Now, others are looking at Sweden’s latest idea to protect its lenders, enacted at the end of 2009 — a “stability fee,” or direct tax on banks so that they pay for their own bailouts.

The Swedish idea appears to have resonated in Washington. United States Treasury officials phoned their Swedish counterparts in December, requesting details of the fee. Last week, the Obama administration announced plans for a financial crisis responsibility fee, aimed at its biggest banks and intended to complete the recovery of the cost to taxpayers of the American bank bailout program.

Wow. I wasn’t aware of this. I checked Sweden Finance Ministry website and here is a timeline of the proposal

The Finance Minister said:

During the crisis substantial national resources were put at the disposal of the financial sector to safeguard financial stability. Through the stability fee banks will be paying in savings capital in advance to central government to be used for measures in financial crises. In that way we are ensuring that crisis measures affect taxpayers as little as possible and do not have an adverse effect on the core welfare system,” says Minister for Local Government and Financial Markets Mats Odell.

In connection with last autumn´s stability plan, the Government established a special stability fund to finance measures to counteract the risk of serious disturbance to the financial system in Sweden. The fund is to be built up with fees from banks and other credit institutions. This means that the institutions themselves finance the measures that need to be taken in order to maintain stability in the financial system and safeguard the interests of taxpayers.

The Government proposes that the fee be set at 0.036 per cent of certain parts of the institution´s liabilities according to an approved balance sheet. The fee will be introduced in 2009, but only half the fee will be charged in 2009 and 2010. The Government further proposes that the institutions participating in the guarantee programme will be able to deduct an average of state-guaranteed liabilities from the calculation basis for the stability fee.

Before the start of 2011, the Government intends to present new proposals on the possible design of a risk-differentiated fee in a system combined with the deposit guarantee scheme.

The difference between Sweden’s fee and US fee is the objective. Where Swedes plan to build a future fin crisis fund from the fee proceeds, US wants to use it to recover the money spent by taxpayers on the crisis.

Another interesting thing is the impact of the plan. In Swede small banks were unhappy as they said government would not help them in crisis. In US, large bank were unhappy as being penalised. As Swede plan reaches out to all banks, US one is for banks having assets larger than USD 50 bn.  

According to Swedish officials, the stability fee has been welcomed by the banks that dominate the financial system. Smaller credit and financing companies complained bitterly, though, arguing that they would never be helped by the government in the event of a failure.

In the United States, the reverse is happening. The Securities Industry and Financial Markets Association, representing Wall Street and big banks, is considering a lawsuit against the administration on the grounds that “a tax so narrowly focused would penalize a specific group.”

Sweden again leads from the front. It had valauable lessons to solve a financial crisis, its central bank keeps coming out with new ideas, fiscal consolidation and now this proposal to solve future financial crisis. All from the Swede factory. 

The Swedes now urge the others to follow on the stability fee:

Sweden has learned from some of the mistakes it made during the crisis of the 1990s. At that time, it introduced a levy on transactions, but trading activity then migrated to London, where taxes were more favorable, the Swedish finance minister, Anders Borg, said Tuesday at a meeting in Brussels.

Having established and tested the new policies, Mr. Borg urged his European partners, in a letter released Tuesday, to follow his country’s lead and introduce a similar program.

Finance ministers from the Group of 20 world economic powers are scheduled to meet in February and are expected to discuss the issue. At the request of the G-20, the International Monetary Fund is working on proposals for a crisis levy and it plans to deliver a report to G-20 ministers in April. Leaders will examine the issue in June

Does who chairs the Central Bank matter?

January 25, 2010

I came across this very interesting paper on central banking (HT: Ken Kuttner). There are many interesting facets of central banking – which anchor to choose, politics, independence, communications , legal aspects , monetary policy committees etc.

This paper written by Adam Posen and Kuttner looks at central bank chairs/heads. They evaluate whether markets care who heads the central bank. The abstract says it all:

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Rakesh Mohan’s website

January 25, 2010

Former RBI Deputy Governor, Rakesh Mohan has a website now. He has categorised his research work on various Indian economy topics.

 Very very useful stuff.

FDIC- Bank of Engalnd cooperate in resolving troubled cross-border financial institutions

January 23, 2010

This is a nice development and more would follow.

The Federal Deposit Insurance Corporation (FDIC) and the Bank of England today announced their agreement to a memorandum of understanding (MOU) expanding their cooperation when they act as resolution authorities in resolving troubled deposit-taking financial institutions with activities in the United States and United Kingdom.

The MOU represents a commitment by the FDIC and Bank of England to enhance their collaboration to promote greater coordination in the face of distress at banks that operate in the two countries and thus protect the wider public interest. It recognizes the importance of close and effective communication about the operations of financial institutions covered by the MOU and differing national laws, consultation on developing issues, cooperative contingency planning for firms covered by the MOU, and supporting the development of appropriate recovery (going concern) and resolution (gone concern) plans. In such areas, the MOU also underlines the need for the FDIC and the Bank to work closely together with other authorities in the United States and the United Kingdom.

However like US, UK also needs to reorganise and define properly the role of various fin regulators. Bank of England has been given the role of resolution but FSA still looks at the financial system as a whole. Who does what and which fin form comes under which regulator? There needs to be a clarity on these issues.

Bank of England says it is responsible for financial stability but has always positioned itself as a price stability institution.

Primer on Wall Street Pay

January 22, 2010

Doug Elliott of Brookings has written a primer on wall street compensation practices. A nice quick read. Though I think he underplays the role of moral hazard and government’s policy to protect too big to fail. The risks were taken because it led to high compensation and the belief that if it blows up, government would bail them out.

Another problem is the feeling that if I don’t pay the talent would go to other finance industries. Let them go!!

There was and is a feeling that there is some great skill in doing all that jazzy finance. The real skill lies in making finance efficient and low cost for everybody. With these kinds of salaries and fees, we are saddled with a highly inefficient financial system.

The highly paid executives call their country/region financial system efficient and continue to make so much money. Both are inconsistent. If markets are efficient, you cannot be making that kind of money. One could understand if few people made that kind of money. All cannot. There is something wrong with the system and is getting dysfunctional as Paul Woolley calls it. Or wall street culture that only pays itself as Bogle has been saying for so long.

The whole financial sector usually overpays for fancy activities. In this sector a fresher is paid a huge salary and it could be that he does not even understand the difference between assets and liabilities (This is no joke as have met a few).

Then there are others who are highly underpaid. For instance, I have always wondered. Who is doing a more rigorous job?  Someone sitting in a small town in India trying to run a bank branch enabling financial inclusion or someone sitting in a plush office in Mumbai doing Treasury work. Given the challenges of financial inclusion India faces, the former should be highly rewarded as well. I think one big missing ingredient for lack of financial inclusion is the poor incentives. All want to rush to Mumbai/Delhi and enjoy better incentives.

Anyways, before this crisis no one could have imagined primers would be written on these topics. It has become a central issue now. And the way wall street is behaving now as crisis has eased, calls for a lot of introspection. Subbarao gave a speech titled ethics in finance. One can simply say, is there any?

Does Philips curve help in recessions?

January 22, 2010

Zheng Liu and Glenn Rudebusch of San Frasisco Fed have a nice short paper on this topic.

The never ending debate on Philips curve:

Since the fourth quarter of 2007, inflation has declined substantially. During the same period, the unemployment rate has more than doubled. Are these two developments connected?

The well-known Phillips curve model suggests that that the high level of unemployment and pervasive slack in the economy could contribute to the decline in inflation. Many economists argue that the Phillips curve relationship between unemployment and inflation is a key part of the linkage between the monetary policy instrument–the short-term interest rate–and the monetary policy objective of price stability (Rudebusch and Svensson 1999). However, Phillips curve skeptics maintain that there is little empirical evidence of a relationship between economic slack and inflation. For example, Atkeson and Ohanian (2001) find that, from 1984 to 1999, Phillips curve forecasts are no better than naive forecasts that assume inflation will not change, that is that it will be the same over the next year as it has been over the past year.

The paper shows how Philips curve can actually be useful in recessions. The persistent low unemployment rates in future should lead to a lower inflation as well.

This Economic Letter examines recent evidence concerning the connection between unemployment and inflation. We argue that, in a deep economic downturn such as the current one, inflation and unemployment do tend to move together in a manner consistent with the Phillips curve. But, outside of such severe recessions, fluctuations in the inflation and unemployment rates do not line up particularly well. Inflation appears to be buffeted by many other factors. This explains why some studies find only a “loose empirical relationship” between economic slack and inflation. Thus, compared with the relatively tranquil period between the mid-1980s and the mid-2000s, evidence suggests that recent high unemployment rates are broadly consistent with the sizable decline in core inflation since the fourth quarter of 2007, a relationship that broadly fits the Phillips curve model.

Read the paper for the analysis. Very simply explained.

However, the authors add caution:

Our statistical evidence should be interpreted with some caution. Our evidence does not imply that inflation cannot run up as long as unemployment remains low. Other factors determine inflation beside the unemployment gap. This is an important and painful lesson that we have learned from the experience of the 1970s. For example, supply shocks and commodity price increases can push inflation up. Furthermore, inflation expectations are also likely to be an important inflation driver and are incorporated in modern Phillips curve theories.

But it does not follow that inflation expectations cannot run up. So far, inflation expectations have likely remained stable despite the unprecedented expansion of the size of the Federal Reserve balance sheet mainly because the Fed has clearly communicated its commitment to price stability and, more importantly, market participants view this commitment as credible. To keep inflation expectations under control, it is essential to maintain the Fed’s credibility and the independence of monetary policy from politics.

This is pretty timely as well. UK inflation for December surged to 2.9% from1.9% in November . Though much of it is because of base effect and is just a one time number but was much higher than expectations. Inflation expectations are supposed to be forward looking but research shows much of it is based on current trend as well. So, there is always an issue of causation between inflation and inflation expectations. If UK high inflation trend persists (for whatever reasons), inflation expectations would shift upwards as well. 

Coming back to Philips curve. It would be interesting to look at more historical evidence and see the relationship in other recessions in other countries as well. It could be an important insight.