Archive for January 22nd, 2010

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?

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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.

Volcker Rule

January 22, 2010

So finally Paul Volcker is heard.  After his proposal of seperating the trading activity from commercial banking was ignored for much of 2009, he finally has a say.

Obama announced y’day what he calls as Volcker Rule to curb financial sector risks and size:

Now, limits on the risks major financial firms can take are central to the reforms that I’ve proposed.  They are central to the legislation that has passed the House under the leadership of Chairman Barney Frank, and that we’re working to pass in the Senate under the leadership of Chairman Chris Dodd.  As part of these efforts, today I’m proposing two additional reforms that I believe will strengthen the financial system while preventing future crises.

First, we should no longer allow banks to stray too far from their central mission of serving their customers. 

…..Our government provides deposit insurance and other safeguards and guarantees to firms that operate banks.  We do so because a stable and reliable banking system promotes sustained growth, and because we learned how dangerous the failure of that system can be during the Great Depression. 

But these privileges were not created to bestow banks operating hedge funds or private equity funds with an unfair advantage.  When banks benefit from the safety net that taxpayers provide –- which includes lower-cost capital –- it is not appropriate for them to turn around and use that cheap money to trade for profit.  And that is especially true when this kind of trading often puts banks in direct conflict with their customers’ interests.

The fact is, these kinds of trading operations can create enormous and costly risks, endangering the entire bank if things go wrong.  We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest.  And we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses.

It’s for these reasons that I’m proposing a simple and common-sense reform, which we’re calling the “Volcker Rule” — after this tall guy behind me.  Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.  If financial firms want to trade for profit, that’s something they’re free to do.  Indeed, doing so –- responsibly –- is a good thing for the markets and the economy.  But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people.

In addition, as part of our efforts to protect against future crises, I’m also proposing that we prevent the further consolidation of our financial system.  There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank.  The same principle should apply to wider forms of funding employed by large financial institutions in today’s economy. 

The factsheet is here.

He takes on wall street lobbying  as well:

My message to members of Congress of both parties is that we have to get this done.  And my message to leaders of the financial industry is to work with us, and not against us, on needed reforms.  I welcome constructive input from folks in the financial sector.  But what we’ve seen so far, in recent weeks, is an army of industry lobbyists from Wall Street descending on Capitol Hill to try and block basic and common-sense rules of the road that would protect our economy and the American people.

So if these folks want a fight, it’s a fight I’m ready to have.  And my resolve is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see soaring profits and obscene bonuses at some of the very firms claiming that they can’t lend more to small business, they can’t keep credit card rates low, they can’t pay a fee to refund taxpayers for the bailout without passing on the cost to shareholders or customers — that’s the claims they’re making.  It’s exactly this kind of irresponsibility that makes clear reform is necessary.

Hmm. strong words…i hope there is some action as well. There are some good links on this proposal:

  • WSJ Blog lists econ/expert views of the proposal. 
  • Time to read on Glass Steagall Act. Comparison with Glass Steagall
  • Paul Mason of BBC Blog says Obama is serious with this
  • UK to follow Obama
  • Krugman says unless we really rein in shadow banking nothing will work really

So after Obama proposed the Bank tax (sorry fee), followed by a funny story that wall street planning to build a legal case against the fee, we have another proposal from Obama. There are two ways to think about it – One. it is all happening randomly. Two, Obama admin is waking up to new challenges from the wall street practices/ lobbying everyday.

There is a very useful timeline by WSJ Blog on various US admin initiatives on financial sector. The war does not look over as these are just proposals. Real thing lies in implementation.

Simon Johnson looks at the politics and says it does not look the recent proposals would be passed. He instead suggests to look at making anti-trust cases against major banks.


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