Friday, July 31, 2009

Trading faster than humans can react?

In its search for squeezing out the smallest (and now they really are getting milliseconds-small!) available window of profit opportunity in the financial markets, it appears that investment banks and hedge funds are whole-heartedly embracing the latest equity markets fad - high frequency algorithmic trading (HFT).

Efficient Market Hypothesis claims that share prices change instantly to reflect all available information. However, it is now widely acknowledged that, apart from other factors, markets are exposed to noise trading and random blips which rapidly and continuously destabilizes instantaneous prices. Therefore, theoretically atleast, it becomes possible to make money if it is possible to both access the rapidly changing information and react swiftly in response by executing trades accordingly. The challenge is that the market participants, or atleast the major players, have become fairly efficient in doing both these in fairly short time that these opportunities tend get traded away even before the markets become aware.

To capitalize on precisely such fleeting opportunities, in recent years trading has gravitated towards very high speed computers whose programs take "real-time" share prices and use it to detect or even predict the next instantaneous twitch in the stock market. Then using an algorithmic formula, the computers can buy and sell stocks within fractions of seconds, with the bank or fund making a tiny profit on the blip of price change of each share.

As Bloomberg reports, 46% of the daily volume in the major global equity markets is handled through such high-frequency strategies. In the US markets, HFT firms represent approximately 2% of the 20,000 or so trading firms and account for 73% of all US equity trading volume. They also include proprietary trading desks for a small number of major investment banks, less than 100 of the most sophisticated hedge funds and hundreds of the most secretive proprietary shops. It is estimated that the annual aggregate profits of low latency arbitrage strategies exceed $21 billion, of which Goldman Sachs alone controls 20% or $4 bn a year.

These programs sift through thousands of quotes to look for patterns in equity price movements and makes bets in hundredths of a second to exploit tiny price swings in equities and discrepancies in futures, options and exchange-traded funds. Such super-fast trading takes care of the problem of "latency", or the "delay between a trading signal being given and the trade being made." As Paul Wilmott writes in the Times, "There’s nothing new in using all publicly available information to help you trade; what’s novel is the quantity of data available, the lightning speed at which it is analyzed and the short time that positions are held."

Though traders and supporters feel that this will make markets even more efficient and increase market liquidity, there are serious concerns about how such trading methods can distort the underlying markets, especially when it gets adopted by large numbers of traders. However, as Wilmott points out, previous experience from such common trading strategies like dynamic portfolio insurance (dynamic calibration of fund portfolios to reflect market movements) shows, the positive feedback associated with a popular trading strategy can have damaging effects on the underlying markets. He writes,

"If a fall in the market leads to people selling according to some formula, and if there are enough of these people following the same algorithm, then it will lead to a further fall in the market, and a further wave of selling, and so on... A rise in price begets a rise. (Think bubbles.) And a fall begets a fall. (Think crashes.) Volatility rises and the market is destabilized. All that’s needed is for a large number of people to be following the same type of strategy. And if we’ve learned only one lesson from the recent financial crisis it is that people do like to copy each other when they see a profitable idea."

Or sample this from Zero Hedge, which claims that HFT traders have created an unequal playing field for all investors,

"These HFT's determine the overall market direction, usually without fundamental or technical reason. And based on a few lines of code, retail investors get suckered into a rising market that has nothing to do with green shoots or some Chinese firms buying a few hundred extra Intel servers: HFTs are merely perpetuating the same ponzi market mythology last seen in the Madoff case, but on a massively larger scale. When it all blows up, the question is whether the SEC will go after the perpetrators of this pyramid with the same zeal that it pursued Madoff himself... HFT has become the biggest cash cow for Wall Street... Long-term buy and hold investors have already departed the market, as they have realized the traditional methods of approaching stock valuation such as fundamental and technical analysis have gone out of the window and been replaced by such arcane concepts as quant factors."

And Felix Salmon describes it as,

"a black box which very few people understand, and that one thing we’ve learned over the course of the crisis is that if there’s a financial innovation which doesn’t make a lot of sense and which is hard to understand, there’s a good chance there’s systemic risk there."

Jon Stokes has an excellent description of the world of HFTs with its global network of supercomputers with "predatory algorithms (that) trawl the information stream, competing every millisecond to gain an informational advantage over rivals". He writes,

"Not everyone is convinced that liquidity is worth the attendant risks of HFT, which are very difficult to quantify when you're looking at HFT's potential impact on the market as a whole... there's... the possibility that HFT, with all of its enormous speed and complete automation, poses a larger systemic risk to our markets... It could be that this fast-moving system as a whole could quickly and dramatically fail in some unforeseen way, due to a combination of an external shock and unseen internal fragility... HFT's combination of speed, volume, secrecy, and lack of human oversight and intervention worries even those who trust the human players not use their machines to cheat at the game."

Update 1
NYT op-ed on HFT and flash trades.

Update 2 (7/3/2010)
Richard Olsen argues that the discipline of high-frequency trading can revolutionise economics and finance by turning accepted assumptions on their head and offering novel solutions to today’s issues. He writes, "High-frequency data is a term used for tick-by-tick price information that is collected from financial markets. The tick data is valuable, because they represent transaction prices at which assets are bought and sold. The price changes are a footprint of the changing balance of buyers and sellers."

Thursday, July 30, 2009

Global macroeconomic re-adjustments are inevitable

The irrational exuberance about "green shoots" is getting to me. There are no simple solutions to the problems that have brought the world economy to its present plight. I have written many times before here, here, here and here. In an earlier post, I had written about an essay by André Lara Resende and about the importance of restoration of financial market confidence and revival in asset values to remove the debt excesses from the financial markets.

To reiterate, a sustainable global economic recovery, one which does not inflate another bubble to recover from the previous bubble (as happened with the credit bubble in the aftermath of the technology stock bubble), would demand a more fundamental re-adjustment of global economic patterns in both consumption and savings and trade.

The present creditor nations will have to boost local aggregate demand by encouraging its consumers to spend more. Further, they will also have to broaden and deepen their financial markets to provide more avenues for domestic lenders/investors to invest their monies. And these government will have to refrain from currency manipulations which not only keeps their exports artificially competitive but also makes imports expensive for domestic buyers. And it also puts pressure on Central Banks against moderating, leave alone loosening, monetary policy even in response to loose external credit environments.

For the debtor nations and its consumers, businesses and governments, the adjustment will have to be more profound. Despite the paradox of thrift, they will have to encourage their citizens to save more and consume atleast a little less. These governments will have to facilitate their businesses to export more. But more importantly (and this has been side-stepped in much of the discussion surrounding rectification of global macroeconomic imbalances), it is imperative that financial markets be better/tightly regulated so as to ensure that there are no easily available irresistable arbitrage opportunities.

This in turn means that the loose money policy has to be reined in as soon the economy starts its recovery. However, this comes up against the widely help opinion that the Japanese recovery in late nineties in the aftermath of the bursting of the real estate lending bubble and first round of pump-priming through government spending was nipped in the bud by the failure to maintain monetary policy loose. In the present case, a delicate trade off will have to be done between the two conflicting results of tightening the monetary policy - on the positive side, preventing financial market distortions with its attendant longer-term consequences, and on teh negative side, squeezing growth and recovery by both raising the cost of capital for businesses and increasing the debt burdens on the mortgage holders and other retail debtors.

Achieving a delicate balance between these two, while following a relatively tighter monetary regime, can be achieved with a dose of inflation - which by reducing the real debt burden, can help alleviate some of the pain - and controlled devaluation/depreciation - which adds to the health of the external sector. But the pitfalls are that both leave open the possibility of uncontrollable inflation and devaluation spirals.

It is futile to hope that extremely loose credit policy, fiscal spending and extraordinary expansion of the balance sheets of the Fed can ensure a return to the Great Moderation age of the last two decades. A long period of pain, similar to the Japanese experience, is inevitable. The challenge is to manage this transition with the least possible damage. Normalcy cannot be restored without undergoing this transition. And all this means a long drawn out, L-shaped, recovery during which the pain of re-adjustment will be felt by different stakeholders. And this process of recovery will considerably eased if confidence can be restored to the financial markets and asset values start their recovery.

Needed - a two-tier tax enforcement machinery?

Businessline reports that an increasing number of the rich in India are now beginning to file income-tax returns. It points to a sharp rise in the number of assessees who filed return of income between Rs 1 crore and Rs 5 crore a year during the last three financial years, increasing from 15,473 to 22,341 and to 26,275 over the three years till 2008-09.

Now, by any yardstick, 26,275 is a laughably low figure for those who filed incomes in the range of Rs 1-5 Cr. The same is the case with those with incomes greater than Rs 5 Cr. I am sure that even a cursory listing of our most likely crorepatis - owners of major industrial houses, higher level corporate executives, software and technology millionaires, bankers and financial market professionals, rich politicians, high earning leading professionals from various fields, film artists, sports persons, and those purchasing high value purchases like real estate, vehicles etc - should easily yield a number that is a multiple of those assessed now.

Now, I am not very aware of the rules and regulations, and the bureaucracy and limitations that the former imposes on our taxation system. But even assuming a very versatile and easy to evade system, for administrators, it surely ought to be easier to focus a couple of lakhs of high income assessees, as against managing the entire tax base. Presumably, this would require a two-pronged approach by the tax enforcement machinery. In addition to the regular tax administration, there will have to be focussed attention on these high value assessees. Though, not supported by figures, I am inclined to believe that the much discussed and acclaimed widening of tax base over the last decade has been effective more at the bottom of the tax pyramid than at the top, where it continues to remain constricted.

It is in this context that the ongoing debate in the US, where there is a gathering momentum, even among conservatives, on increasing marginal tax rate for those at the top of the pyramid, atleast to finance long-term challenges like health care and social security.

Wednesday, July 29, 2009

RCTs as electoral strategy

Governments are naturally reluctant to subject their programs, especially those involving individual welfare handouts, to rigorous impact evaluation. What happens if the program is found to have not delivered on what it promised? This has confined academic researchers and program evaluators to analysing programs funded by Non-Governmental Organizations and multi-lateral institutions and thereby seriously limited their canvas of study. However, I am inclined to believe that it may be an electorally prudent strategy for governments and ruling party representatives to embrace program evaluations like randomized control trials (RCT). Here is why.

Program evaluation by way of RCTs can be beneficial for politicians facing elections besides providing valuable learnings about the impacts of various development program components. RCTs perforce divides the target group into two randomly distributed treatment and control groups. In other words, one half is administered the welfare benefit while the other half is denied the same.

The situation is tailor-made for the ruling party politician to offer the incentive of extending the program to the other half in return for re-electing him. This is likely to over-ride any ill-effects of them having been denied the first chance of sharing in the benefits of the program. They can also be incentivized with the prospect of a revamped program that is more effectively administered and whose punch for the beneficiary is greater, a result of the lessons learnt from the RCT evaluations. Presumably, the first half should be happy in two ways - at benefitting from the program and more so when his neighbour has not!

Interestingly, by the same logic, randomized phasing of welfare programs will also contribute towards the sustainability of the program even in the case of a government change. The overall success of the program in delivering welfare benefits and the fact that half the group have not got their share of the benefits will maintain the pressure on the new government to continue the program, if only to deliver the benefits to those hitherto denied their share.

Randomization into two (or more) groups is also beneficial to the ruling party in so far as they can now more optimally utilize the scarce resources available by covering only one-half of the population without losing the loyalty of the other half. They can therefore use the same resources to now cover two or more programs. Further, since the beneficiaries are randomly and transparently selected, instead of the usual partisan manner, the government may find it easier to rationalize away any discontent amongst those denied the benefits.

However, it is important that on the net, these programs deliver substantial benefits to those in the treatment group. This is rarely a problem since any new welfare program would deliver some benefit or the other to its beneficiaries, in its own ineffcient and poorly targeted manner. The challenge is only to design it to deliver the greatest bang for the buck and to the specific target group.

This approach was adopted in Mexico when the PROGRESA Conditional Cash Transfer scheme was first launched in 1998 in only half of the 506 targeted communities. It has been claimed that the randomized phase-in of the program (and the resultant ability to incrementally make changes based on the results of the RCT results) has played a major role in ensuring the continuity of the program despite the governmental change in 2000.

Tuesday, July 28, 2009

Health insurance and obesity

The insurance market is bedevilled with numerous classic market failures arising from adverse selection and moral hazard. Now, in the latest moral hazard problem, Freakonomics draws attention to an NBER working paper that claims to establish a positive causal link between obesity and health insurance.

Jay Bhattacharya, Kate Bundorf, Noemi Pace, and Neeraj Sood tested the proposition that body weight is influenced by insurance coverage and found strong evidence that being insured increases body mass index and obesity. They trace this moral hazard due to the fact that the obese do not pay for their higher medical expenditures through differential payments for health care and health insurance.

In a pointer to the utility of incentives for healthy behaviours, they write, "These effects are larger in public insurance programs where premiums are not risk adjusted and smaller in private insurance markets where obese might pay for incremental medical care costs in the form of lower wages."

I am inclined to believe that the aforementioned study offers interesting lessons highlighting the pitfalls inherent in randomized program evaluations. While intutively persuasive, this hypothesis appears to be not borne out by macro-level evidence - Europe with higher health insurance coverage, and that too publicly funded, has much less obesity than the US with its limited and mostly private insurance; and within the US too, it has been well established that the under-privileged, blacks and those more likely to be outside the insurance net suffer disproportionately more from the obesity problem than those insured.

At a theoretical level, the two instrumental variables (IV) used to study the causal relationship between health insurance and obesity (the dependent variable) - percentage of workers employed in private firms (for the causal effect of private health insurance) and the generosity of state Medicaid coverage (for the causal effect of public health insurance) - may not offer accurate reflection of the causal relationship. They would translate into the following

1. States with larger share of workers employed by private firms have more of its residents who are insured. States with larger share of workers employed by private firms have less obesity.
2. States with more generous Medicaid coverage had more people insured. States with generous Medicaid coverage had more obesity.

Now both these "instrument leads to treatment (insurance)" and "instrument leads to outcome (obesity)" statements do not reveal the full truth. First, states with a larger share of workers employed by private firms may be a more progressive state (in terms of its ability ot attract private investments) and therefore may be populated by people who may have less propensity to become obese. Second, the states with more genrous Medicaid coverage are likely to be the poorer and less developed states, which are therefore more likely to be populated by alarger share of people who are more vulnerable to becoming obese. It therefore appears that the IV's are closely corelated with the other variables in the relationship, thereby concealing the true nature of the relationship. The IV estimates may have over-estimated the effects of insurance on bodyweight and obesity.

Monday, July 27, 2009

More from the Economic Survey

Topically dated, but nevertheless relevant. Few more observations from the Economic Survey 2008-09 on subsidies and its impact on government liabilities.

1. On revenue expenditure, while interest payments have been declining from 34.3% of total revenue expenditure in 2003-04 to 24% (or 3.6% of GDP) in 2008-09, major subsidies (food, petroleum and fertilizer) have grown from 12% to 15.3%.

2. Fertilizer subsidies are the worst managed and untouched by any reforms, leave alone efforts to decontrol the industry. In view of a complete freeze in prices of major fertilizers since 2002, farmer's contribution to fertuilizer prices has plunged from 82% to just 18% in 2008-09. Fertilizer subsidies were worth Rs 95,000 Cr in 2008-09. In recent years, the government have issued bonds to fertilizer and oil companies and FCI in lieu of its subsidy liabilities. The liabilities or under-recoveries on the other major subsidies are in the graphic below.

3. Hike in the Minimum Support Prices (MSPs) for grains and increase in buffer stocks to avoid any need for imports, and high priced sugar and wheat imports may have the effect of driving up food subsidies to a high of Rs 55,000 Cr for 2009-10.

4. The liabilities of the central government remain mostly internal and has been showing a positive downward trend during the past five years. Thanks in the main the FRBM framework (though FRBM does not explicitly lay down a debt to GDP limit), total liabilities have declined from 63% in 2003-04 to 58.9% in 2008-09, of which inetrnal liabilities have fallen from 61.4% to 56.6%, whereas external liabilities have risen slightly from 1.7% to 2.3%.

Google Vs Microsoft - a race to MAD?

The Cold War and the nuclear arms race between the United States and the Soviet Union had generated a considerable body of research on the dynamics of all such competitions between two agents. It was argued that the rapid accumulation and diversification of the respective nuclear arsenals by both nations, whose only logical climax could have been a form of mutually assured destruction (MAD), was intended to keep each other in check.

This is exactly what Robert X Cringely appears to think of the battle between Microsoft and Google over various computer and internet applications.

Cringely feels that the competition by Microsoft and Google to release their own versions of applications to compete against established products of their competitor is aimed more at keeping their competitor on its toes than at capturing the market. He sees such salvos as attempts to remind each other of their respective prowess.

He writes, "Microsoft makes most of its money from two products, Microsoft Windows and Microsoft Office. Nearly everything else it makes loses money, sometimes deliberately. Google makes most of its money from selling Internet ads next to search results. Nearly everything else it does loses money, too."

After having unleashed its Chrome web browser against Microsoft's Windows Internet Explorer and its Android smart-phone operating system against Microsoft’s Windows Mobile, Google has now unveiled its Chrome Operating System (initially for use in low-cost portable computers called net books) against Microsoft's Windows OS. Microsoft has not been far too behind, having already released its new search technology, Bing, against Google's world beating search engine.

Admittedly Google claims that its Chrome browser and OS are a step towards moving from the age of PC-computing to web-based "cloud computing". There is a strong belief among some obaservers of computing that Chrome moves us further away from running code and storing our information on our own PCs toward doing everything online — in the cloud — using whatever device is at hand.

Sunday, July 26, 2009

More on the impact of NREGS

This post is in continuation to the discussion, here and here, on the impact of higher NREGS wages on different types of farmers and the rural economy. In response to a comment in one of those posts, here is my conjecture of the impacts of NREGS.

Farmers with large land holdings
Rely on farm labor to till their lands. Therefore, will be affected by the increase in their wages. However, unlike those with mid-level holdings they may be able to afford the higher wages, though it will certainly affect their incomes. Their labor demand curve is relatively inelastic, and therefore are likely to experience a smaller labor deficit of only Q(mkt)-Q(nreg).

Farmers with mid-level holdings
Also rely on farm labor. Typically, they work on their fields alongside the farm labor. Are more sensitive to increases in labor wages, given their lower income profile. Their labor demand curve is more elastic and they will experience a substantial labor deficit of Q(mkt)-Q(nreg).

Small farmers who are willing to work under NREGS
They will get higher wages now. And their exit will reduce the supply of farm labor, thereby forcing up farm labor wages.

Small farmers who do not go to work under NREGA
The higher wages offered under the NREGS will incentivize them to defect to NREGS works. Even if they do not, they will still end up with higher farm wages arising from the decreased supply of farm labor due to the NREGS.

Viability of agriculture
The long term impact of the higher wages on agriculture output is likely to be minimal. In fact, it could be a much needed filip to boosting farm productivity. It needs to be borne in mind that our agriculture remains caught in a low productivity trap, arising partly from deficient capital investments (both government and farmers) and also incentive distortions (among both farmers and the agriculture labor).

Higher farm wages can incentivize large farms to become more productive by greater mechanization, more effective deployment of labor etc. This productivity effect could be more pronounced in the mid-level holdings, where farmers are more sensitive to higher wages. Higher food prices could also encourage and increase the efficiency of subsistence production.

Prices of agricultural output
I have blogged on this earlier here, "Since labour is a significant component of agriculture costs, any rise in this input cost will put upward pressure on foodgrain prices. Production costs will rise, and atleast a share of the increase will be passed on to the consumers by way of higher foodgrain prices."

Un-skilled construction workers
Another industry where the higher NREGS wages could have some effect is on the market for un-skilled construction workers, who are now typically paid Rs 60-100 per day, often at locations outside their villages and even in towns. They may find the local employment opportunities afforded by NREGS at similar or higher wages. There could be a consequent upward pressure on construction wages.

Mint too believes that "NREGS has created a wage-floor for an otherwise hapless pool of unskilled rural labourers" and that "higher farm costs from a decrease in labour supply are a reality in many parts of India".

Update 1
Shamika Ravi and Monika Engler examined the welfare impact of the National Rural Employment Guarantee Scheme (NREGS), as measured by the changes in expenditure level and physical and mental health indicators, and finds that the program has had a "significant impact in alleviating rural poverty".

It finds that food expenditures, which generally account for about 60% of total consumption, increases by 15% for the weaker section of the population, and the impact on food security increases with the vulnerability of the target group. Spending in non-food consumables and clothing increases by 40-50% among the less well off participants. Further, it also finds a significant decrease of emotional distress in the form of anxiety, tension, and worries, all of which contributes towards increasing the productivity of these individuals.

Update 1

The hypothesis that NREGA has drawn off people from far labor is not borne out (atleast) by the graphic below. The share of agricultural labor has remained more or less constant since the NREGA was introduced.

Update 2
Businessline writes, "While not impacting too much the medium and large farmers with other sources of income, the rural employment guarantee scheme has hit smaller and marginal farmers, for whom labour has become high-cost and scarce because of the NREGS".

China's forex reserves cross $2 trillion

Brad Setser points attention to the fact that Chinese foreign exchange reserves crossed $2 trillion, doubling in less than three years, in April. The Chinese holdings of US Treasuries is expected to top $1 trillion later this year.

And despite all talk of diversifying away from dollar-based assets, the Chinese holdings of safe US assets (treasuries, agency debt, short term bank claims) have been growing in line with its reserves, though holdings of riskier US assets (corporate bonds and equities) have tapered off.

Too-interconnected to fail?

Daniel Little sees strong parallels between the post-war American economy and polity as described by C Wright Mills in his Power Elite, and the networks of influence in the American politico-economic establishment today. Mills had talked of a hidden system of power and influence wielded by decision makers at the top ("in positions to make decisions having major consequences") that negated many of the democratic ideals. Much the same is evident in the America of today, and the most salient (and even ubiquituous) manifestation of this is the all-pervading influence of Goldman Sachs in the American political and corporate establishment.

Little first describes the power relationship described by Mills,

"There is a small subset of the American population that (1) possess a number of social characteristics in common (for example, elite university educations, membership in certain civic organizations); (2) are socially interconnected with each other through marriage, friendship, and business relationship; (3) occupy social positions that give them a durable ability to make a large number of the most momentous decisions for American society; (4) are largely insulated from effective oversight from democratic institutions (press, regulatory system, political constraint). They are an elite; they are a socially interconnected group; they possess durable power; and they are little constrained by open and democratic processes."

And then makes the comparison with modern day America,

"Corporations continue to have enormous influence on our society - banks, energy companies, pharmaceutical companies, food corporations. In fact, the collective power of corporations in modern societies is surely much greater than it was fifty years ago, through direct economic action and through their ability to influence laws and regulations. Their directors and CEOs do in fact constitute a small and interlocked portion of the population. And these leaders continue to have great ability to determine social outcomes through their "private" decisions about the conduct of the corporation. Moreover, as we have learned only too well in the past year, there is very little regulative oversight over their decisions and choices."

He refers to a network graph of corporate America that reflects the high degree of interconnectedness across the boards of directors of major American corporations.

The net result of all this is the presence of a small subset of the population who occupy most of the positions of power, and whose postions confer an unfair advantage on their sons and daughters in the race for power in their generation.

Update 1
Mark Thoma feels that the markets are too inter-connected that risks are not as widely dispersed as conventionally thought of.

Update 2 (5/4/2010)
Mark Thoma has this post on the importance of interconnectedness.

Saturday, July 25, 2009

When markets fail in education and health

It has for long been widely argued that free-markets do not provide the most efficient, and, certainly not, the fairest outcomes in areas like health care and education. Markets in these sectors are characterized by asymmetric information problems like adverse selection and moral hazard. The recent work of behavioural economists have added weight to such arguements.

Two interesting working papers illuminates the possibility of market failures in the market for health care and education.

It is argued that health care quality report cards (public disclosures of patient health outcomes at the level of the individual physician and/or hospital) help to allocate the sickest patients to the highest quality providers. However, using US national data on health care quality report cards of Medicare patients, researchers Dranove, Kessler, McClellan, and Satterthwaite found that on the contrary, it gives providers the incentive to totally decline to treat sick patients in order to improve their quality ranking.

They found that data of patients at risk for cardiac surgery was used by health care providers to filter patients and prefer/select more healthy patients for surgery. In other words, as the authors write, "Existing cardiac surgery report cards decrease patient and social welfare on net" and more needy patients end up with under-provision of services.

In a more recent working paper, W.Bentley MacLeod and Miguel Urquiola, find similar market failures and inefficient outcomes with respect to school reputation (measured by the achievements of its graduates) and the market for education. It had for long been argued that a free market in which schools compete based upon their reputation would lead to an efficient supply of educational services. However, research based on the economics of tipping point based segregation, have claimed that such competition invariably leads to inefficient and unfair outcomes.

The authors agree that if schools cannot select students based on their ability, then a free market is indeed efficient and raises school performance and student outcomes. However, if there is a possibility for them to select students based on innate ability by leveraging their reputation, then "competition leads to stratification by parental income, increased transmission of income inequality, and reduced student effort (all students face weaker incentives for academic effort) - in some cases lowering the accumulation of skill - and lower incomes for students who do not gain admission to selective schools".

In other words, in a selective school system, there is an "anti-lemon effect" - entry by relatively small schools that serve students within a specific ability range. In contrast, in a non-selective school system (where the distribution of student innate ability is the same at every school), competition leads to efficient outcomes - both student academic effort and improvements in school value addition are incentivized.

Further, if an educational system has poor measures of individual performance, then the market will set wages using other observable characteristics, such as the identity of the school or the district a student attended. In such cases, superior students from under-performing schools have no way to signal their skill, and will therefore rationally divert effort toward non-academic activities. The superior students in the good schools, firmly assured of attractive labor market placements, have an incentive to not stretch themselves to their limits and ride with the group. Even the not-so-good students in the high-reputation schools are likely to get attractive offers in the labor market by default.

The authors also claim that selective school systems are likely to be resistant to reform since parents with children at schools with good reputations will rationally resist efforts to make schools less selective. This makes it difficult to enhance school performance by reducing selectivity. They therefore propose the enhancement of individual incentives by the introduction of more rigorous standardized national testing, that would provide an alternate way to enhance performance.

They also claim that selective school systems "may help explain why it is so difficult to enhance school performance in urban areas where competition for admission into selective schools leaves many students behind in schools with adversely selected populations". Therefore, expecting a lower return from academic study, these students will rationally allocate their time to non-academic activities such as sports, part time jobs, crime, and parenthood.

Update 1
Paul Krugman points to Kenneth Arrow's paper on why health care cannot be market like any other good and explains "why health care cannot be cured by the free market system".

Friday, July 24, 2009

The "too big to fail" tax

Free Exchange points to the momentum gathering around a tax to internalize the massive external costs inflicted by the "too big to fail" institutions.

It was the always perceptive William Buiter who initially advocated a tax on such banks.

When size creates externalities, do what you would do with any negative externality: tax it. The other way to limit size is to tax size. This can be done through capital requirements that are progressive in the size of the business (as measured by value added, the size of the balance sheet or some other metric). Such measures for preventing the New Darwinism of the survival of the fattest and the politically best connected should be distinguished from regulatory interventions based on the narrow leverage ratio aimed at regulating risk (regardless of size, except for a de minimis lower limit).

And now the sheer chicanery associated with on the spectacular second quarter profits of Goldman Sachs and its massive executive compensation payments has left even the ultra-conservative Wall Street Journal proposing a "bailout tax",

"One policy response to the incentives created by last fall's bailout is simply to restrict the proprietary trading done by the subsidiaries of bank holding companies that enjoy both FDIC deposit insurance and an implicit government subsidy on their cost of capital. This is what Paul Volcker proposed, only to be overruled by Tim Geithner and Larry Summers. Another answer would be an FDIC-style bailout tax, perhaps tied to leverage ratios, for those in the too-big-to-fail camp. Developing a template to facilitate the seizure and orderly winding down of failing financial giants is also an essential element of whatever reform Congress cooks up."

Felix Salmon too supports the idea,

"There really is a public good to be served in taxing what you want less of — which is too-big-to-fail banks making outsize bets with other people’s money (backstopped by the taxpayer, of course) and then paying themselves billions of dollars in bonuses. The WSJ’s bailout tax idea is a good one — especially if it rose in line with a financial institution’s balance sheet, and gave those institutions a serious incentive to shrink. If you can’t legislate a hard cap on assets, then you can at least provide some gentle encouragement to get smaller rather than bigger."

In fact, in order to limit the "too big to fail" hazard, Buiter even proposes that only governments do certain banking activities

"Governments everywhere should be focusing on breaking up banks and keeping them small. If some banking activity (or indeed any other economic activity) is deemed to have a minimum optimum scale that is makes it too large to fail, it should be publicly owned. Small is beautiful for banks."

And about keeping banks small he writes,

"There is no economic reason for large banks. Therefore banks should be kept small. An obvious mechanism (apart from aggressive anti-trust policy) is to tax bank size. One way to do this is through making regulatory capital requirements increasing in the size of the bank’s activities. For instance, tier one capital as a share of (unweighted) assets could be made an increasing function of the value of the assets. Gary Becker has made a similar proposal."

Update 1
James Surowiecki traces the reasons for bank size being persistently being big - account switching costs, government subsidies and guarantees (moral hazard which keeps consumers with the larger banks), and the banks’ market power (which increases the market credibility of the advice/service offered). See also James Kwak here.

Update 2
Finally the Obama administration is apparently considering a tax on banks that pose systemic risks so as to recover the atleast $120 billion it spent to bail out the financial system. Under consideration is a tax based on the size and riskiness of an institution’s loans and other financial holdings, or a tax on profits. However, this would be different from a global transactions tax, as suggested by the EU, or a windfall tax on bonuses. See Simon Johnson and this debate on bank tax.

State of the dismal science

Economist explores the state of economics today in the aftermath of the sub-prime crisis in two articles that question the state of macroeconomics and financial economics - "macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it". It writes,

"Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street’s most esoteric instruments were built on these ideas."

It finds that most standard macroeconomic models and theories paid inadequate or even no attention to the workings of the financial markets, which were seen as a black box whose utility lay only in channelling savings into loans for invesmtents. As the article writes,

"Modern macroeconomists worried about the prices of goods and services, but neglected the prices of assets. This was partly because they had too much faith in financial markets. If asset prices reflect economic fundamentals, why not just model the fundamentals, ignoring the shadow they cast on Wall Street?... In many macroeconomic models, therefore, insolvencies cannot occur. Financial intermediaries, like banks, often don’t exist. And whether firms finance themselves with equity or debt is a matter of indifference. The Bank of England’s DSGE model, for example, does not even try to incorporate financial middlemen, such as banks... The mainstream macroeconomics embodied in DSGE models was a poor guide to the origins of the financial crisis, and left its followers unprepared for the symptoms."

About the failure financial economists , it writes,

"Few financial economists thought much about illiquidity or counterparty risk, for instance, because their standard models ignore it; and few worried about the effect on the overall economy of the markets for all asset classes seizing up simultaneously, since few believed that was possible."

Another blindspot in formal macroeconomic training arose from the excessive fixation, to the exclusion of all else, with preservation of price stability (inflation targeting) and, to a lesser extent, economic growth. There was nothing to guide Central Banks about when to shift objectives from preserving price stability to safeguarding financial stability. In other words, there was nothing to help central bankers make the decision of when to take the punch bowl away.

Chris Dillow provides an excellent Marxist (or "neo-Marxist"!) perspective by analyzing the failure of financial institutions to manage risk properly from the principal-agent framework. He claims that agency problems within banks militated against understanding risks like tail risk, correlation risk, liquidity risk and counterparty risk. He draws attention to Marx's allusion to "the hidden abode of production", where he examined the issue of how income was distributed between profits and wages, and which was ignored by all orthodox macroeconomic theories.

More on exit strategy for central banks

I had blogged earlier about the possible exit strategies for Central Banks from the extraordinary balance sheet expansions (through lower interest rates, targeted lending programs, purchases of long term and other securities etc) of the past few months. As economic recovery takes hold, it becomes imperative that the monetary base be contracted, so as to ensure that inflationary pressures are kept under leash.

Banks are required to hold a certain fraction of their liabilities - demand deposits and other checkable deposits - in reserves held at the Central Bank (on which the Central Banks pays no interest) or in vault cash. They are constrained in the amount they can lend by the statutory reserve requirements (like Cash Reserve Ratio, CRR, in India). The bursting of the sub-prime bubble had severely depleted their deposits and consequently the reserves available to leverage for lending. The Central Bank liquidity injections have had the effect of boosting bank reserves, and increasing their ability to lend. However, the increase in reserves have been much faster the growth in deposits and lending, leaving the banks with considerable excess reserves. Further, those banks with excess reserves, in turn on-led their excess reserves overnight to others with deficient reserves.

In the US, these reserve balances now total about $800 billion, much more than normal. In view of the uncertain economic conditions, banks have been holding even their excess reserves as balances at the Fed. However, as the economy recovers and banks find more opportunities to lend out their reserves, unless these excess reserves are eliminated, money supply will grow faster and set the stage for inflationary pressures.

As I had posted earlier, the Central Banks can prevent the reserves entering the money market (since the banks indulge in short-term, mostly overnight lending of tehse excess reserves) either by raising the statutory reserve requirements or by paying interest (higher than the prevailing money market rates) on the excess reserves. Across the world, a few central banks like the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility.

In a WSJ op-ed (and testimony before Senate), the US Federal Reserve Chairman, Ben Bernanke reassures about the massive Fed balance sheet and reserve supluses with banks and outlines four ways to reduce reserves and drain excess liquidity from markets, and thereby also raise short-term interest rates and limit the growth of broad measures of money and credit.

1. Fed could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

2. Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline. Treasury has been conducting such operations since last fall under its Supplementary Financing Program.

3. Fed could use the authority Congress gave it to pay interest on banks’ reserve balances at the Fed to offer term deposits to banks — analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

4. The Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Mohamed El-Erian of Pimco argues that Bernanke's message is a clear signal to the markets that the Fed has enough arsenal in its armory to move from arresting deflation to fighting inflation. He sees Bernanke's reiteration of the widely held perception that loose monetary policy will have to continue for an "extended time", atleast till the green shoots turn into saplings, as indication of the critical importance of fiscal policy in achieving the same.

In the final analysis, the critical issue, as both Mark Thoma and Economix writes, is not how the Fed drains out or prevents the excess reserves from flooding the market, but when should it start winding down these reserves. As Economix writes, "Unwind too soon, thereby draining liquidity from the system, and they short-circuit all the efforts to get the economy to recover. Take action too late and they cause massive inflation."

Update 1
Amidst the debate on exit strategies, with the dilemma in choosing between inflation and unemployment, all strategies have focussed on the role of bank reserves (or the money held by banks to meet their credit requirements and whose excess they lend out to other banks, as interbank loans, at the federal funds rate - if the Fed wants a higher fed funds rate, it drains reserves, and if it wants a lower one, it adds reserves). Free Exchange feels that the volume of reserves has almost no significance for the growth of bank lending and inflation when both credit demand and supply are constrained, especially at zero bound when they become irrelevant in managing the fed funds rate.

Thursday, July 23, 2009

Mint op-ed on soap operas and family planning

Here is my Mint op-ed on the utility of the lessons from experimental techniques in public policy making. See also this earlier post.

Managing electricity demand

Managing peak electricity demand is one of the biggest challanges for electricity utilities across the world. Massive investments are made in constructing and maintaining peaking power generation plants to meet this peak demand. In the circumstances, one of the primary objectives of recent initiatives like that for a smart grid is to manage peak demand through triggering off demand response in consumers by incentivizing them to reduce their consumption at peak times using variable tariffs.

A French energy demand management company, Voltalis, has come up precisely such a solution and have installed these devices in over 5000 such consumers across the country. Voltalis installs electricity management devices in private homes and businesses and then manages their use for a fee. This will enable consumers minimize their electricity bills, by keeping consumption low when the demand and prices are at their highest, and manage peak demand to the benefit of the grid as a whole. Voltalis says that its "distributive load shedding" technology can save users as much as 10% on their electricity bills and save power producers billions in investments in new plants used only to meet peak demand.

Voltalis’s Bluepod boxes, free to consumers, plug into the home electrical panel and communicate back to the company’s computers by Internet. When, for example, summer demand on the electrical grid nears a peak, the system would automatically turn off air-conditioners for hundreds or thousands of consumers willing to give up the coolers for a short time to avoid the need for additional electrical production to come on line.

However, in a surprise decision, the French Energy Regulatory Commission (CRE), has directed Voltalis to pay generators for the power its actions end up saving instead of being paid by generators for reducing consumption and maintaining supply and demand equilibrium during peak demand times. The CRE ruled that Voltalis should pay the power company because "its service would not be possible without the producer maintaining production".

The decision has been criticised as being an exmaple of how entrenched interests within the sector do not allow newer technologies to emerge. Électricité de France, the leading state-owned generator, has taken tentative steps of its own toward the distributed load shedding technology, and may have forced the regulators hands so as to nip off any competition.

Wednesday, July 22, 2009

The impact of rising government borrowings

The Union Budget has put the fiscal deficit for 2008-09 at 6.2%, up from 2.7% in the face of a Rs 1,86,000 Cr fiscal stimulus. Though it projects the deficit to remain at 6.8% for 2009-10, all indications are that it will go well beyond this target. However, the Government have also announced its intent to make earnest efforts to cut fiscal deficit as a percentage of GDP to 5.5% in 2010-11 and 4% in 2011-12.

In the coming year, the Central Government is estimated to borrow Rs 4.51 lakh Cr (an increase by 50%) and the state governments (in the face of borrowing limits relaxation from 3.5% of state GDP to 4%) in another Rs 1.61 lakh Cr, taking the cumulative sovereign debt issuance for dated securities to at least Rs 6.12 lakh Cr.

Apart from the fiscal stimulus, this high central borrowings is due to the larger requirement for discount on treasury bills, and interests (coupon payments) on market loans, special securities to oil marketing companies (Rs 10,511 Cr against Rs 5529 Cr in 2008-09) and fertilizer companies (Rs 1,956 Cr against Rs 609 Cr last year), state provident funds, insurance and pension funds.

Recently the Government of India decided to step up its first half year borrowing programme by nearly 25% (or Rs 58,000 Cr) to Rs 2.99 lakh crore, in order to fund "a higher-than-anticipated fiscal deficit, owing to higher social sector spending and lower revenue receipts".

By front-loading its borrowing targets, the Government hopes that it can raise the bulk of its borrowings before recovery is under way, thereby ensuring that its borrowings do not compete with the expected increase in demand for private borrowings if (and this is a big "if"!) the economy picks up full steam in the second half of the fiscal year.

Since the government have already borrowed Rs 1.89 lakh crore from the market, it will raise the balance Rs 1.10 lakh crore till September 30 in ten tranches. The government will issue papers of 5-20 years maturity. Besides, it will also roll over treasury bills worth Rs 86,500 Cr in the proposed auctions.

Encouragingly for the government, banks have been parking an average of about Rs 1.2 lakh Cr evey day (touching even Rs 1.50 lakh Cr) with the RBI through its reverse repo auction window since April, which is up from an average of Rs 46,000 Cr every day in the previous three months. Further, the demand for liquidity through the RBI’s open market operations (OMO) to purchase government securities and thereby expand credit supply, was low.

As Businessline reports, at the OMO auctions, the weighted yields accepted for the 6.05% 2019 and the 7.95% 2032 securities were 6.98% and 7.84% respectively, indicative of the comfortable liquidity position. All this are clear indications of a banking system flush with funds, but unwilling to take credit risks and therefore preferring the safety and liquidity of Government securities despite their lower returns. Though, the RBI had said in March that it would buy about Rs 80,000 Cr worth government bonds through OMOs in the April-Spetember 2009 period, it has so far been able to purchase only Rs 29,850 Cr in the three-and-half months (against the aggregate notified amount for the period for Rs 43,500 Cr).

However, given the magnitude of borrowings, the government may be fighting strong headwinds to stave off higher interest rates some time this year. It is expected that the sheer magnitude of government borrowings would drive up the benchmark interest rates on long term G-Secs. As the graphic below indicates, the yields on 10 year G-Secs have been on their way up.

By deploying such huge amount of resources in stimulating aggregate demand and preventing the economy slowing down considerably, the Government of India may have played its final hand. The success of the stimulus program depends on a series of factors developing along favorable lines

1. The stimulus spending itself will have to deliver the biggest bang for the buck, in generating spending multipliers that stimulate aggregate demand.
2. It will have to "crowd-in" private investments, especially in sectors like infrastructure construction, so that the government investments can leverage private investments to generate a higher than other-wise possible level of investments.
3. Hope that both the aforementioned revives aggregate demand by enough to ensure that growth is sustained even after the bulk of the stimulus runs out by the end of the year. If demand continues to remain weak, the government could be caught in a vicious spiral - weak economy, higher debt service burden and declining tax revenues.
4. Hope that the government borrowings do not have the effect of "crowding-out" private borrowings and thereby snuffing out the emergent buds of revival of economic growth.
5. If the economy recovers before the government borrowings end, the government will end up competing with private borrowers in thee credit markets, thereby putting upward pressure on interest rates.
6. The higher deficits causes Ricardian equivalence to set in, leading consumers to postpone their purchases and save more in the expectation of higher taxes in future.
7. Finally, even if all the aforementioned goes according to plan and recovery is well under-way, there is the very strong possibility of inflation rearing its head and creating another set of equally challenging and complex problems. Inflationary pressures can also arise from the increase in monetary base as this deluge of government spending finds its way into the economy.

Tuesday, July 21, 2009

The Indo-US carbon emissions controversy is another reason to favor carbon taxes

This blog has consistently argued in favor of carbon taxes over cap-and-trade measures to control the emission of greenhouse gases. The disagreement between the US and India on how to address the challenge of greenhouse gas emissions and its possible consequences adds further weight to the view that carbon taxes are the way ahead.

The Indian government has reiterated its opposition to any binding limits on carbon emissions. It claims that its per capita carbon emissions are only a fraction of that of the US and other developed nations and any binding limits on emissions would adversely affect its economic growth.

Two recent developments - a WTO decision to permit a broad set of border-tax arrangements (border adjustment measures) by countries implementing cap-and-trade systems for greenhouse gases against those not adopting such measures and the adoption of a cap-and-trade system for curbing carbon emissions by the US which contains a provision to impose border tariffs on those not limiting emissions - are cause for serious concern for developing countries like India. They may have had the effect of crystallizing a national climate change policy that adopts both carbon taxes and cap-and-trade.

Through the American Clean Energy and Security Act 2009, the US has effectively adopted a two-prong strategy to address the climate change challenge - domestically it will use cap-and-trade measures while externally it will resort to carbon taxes on its trade partners who do not commit to binding targets. A recent NYT editorial even points to precendents for using trade measures for environmental goals - the Montreal Agreement to curb the use of ozone-depleting gases included trade controls on such substances.

I am inclined to believe that the WTO decision, which legitimizes the corresponding provision in the Waxman-Markey Bill, will soon replace traditional issues that divide developed and developing countries - tariffs, labor standards, agriculture subsidies etc - and become the epicenter of global trade negotiations. Developing nations cannot be faulted if they view carbon tariffs, in the guise of border adjustment measures ostensibly to provide level-playing field to local industries, as a back-door entry of protectionism by developed economies.

I have argued that a carbon tax is cheaper, much more economically efficient, creates far less incentive distortions, and simpler to administer. The aforementioned developments and the dangers of protectionism and retaliatory actions that could seriously undermine global economic integration, lends further weight to the superiority of carbon taxes over cap-and-trade measures. Given the practical difficulty of getting developing countries like India to embrace the cap-and-trade mechanism and agree to binding carbon emission targets, carbon taxes look the only agreeable alternative.

Universal and standard carbon taxes on all greenhouse gas emitting goods and services would neither favor nor disadvantage any set of countries over the rest. Since greenhouse gas emissions and its impact on climate change are a global negative externality, it is only appropriate that every product and service inflicting this external cost ought to be taxed, so as to internalize the resultant costs. By dis-incentivizing the activity or product that generates greenhouse gases, it will ensure that the ultimate objective of reducing such emissions is achieved. Further, by being indifferent to the location of the industry generating the greenhouse gases, it eliminates problems like unequal playing field for different national industries and distortions like shifting of industries from one country to another.

The developed economies generally set the agenda for negotiations on various global issues multi-lateral forums like the WTO, IMF, Kyoto Protocol etc. However, this may be a great opportunity for India to lead the developing countries in setting the agenda for the next round of world trade and climate change negotiations by campaigning for a global carbon tax to contain greenhouse gas emissions. Clearly defined proposals on carbon tax as an alternative to cap-and-trade will also ensure that developing countries are not seen as being merely obstructionist but being constructive in addressing one of the most important challenges facing the world.

Update 1
It appears that the emissions reporting in the US is murky, in so far as the claims on reductions achieved is "murky".

Monday, July 20, 2009

Goldman Sachs and the art of making money during bubbles

I had blogged earlier about the special ability of Goldman Sachs to make money even in a bust and about the fact that they have emerged as easily the biggest winner out of the sub-prime crisis! With the economy still on its knees, Goldman has announced massive profits accompanied by huge bonus and executive compensation payouts to its executives and traders. The irony, bordering on fraud, inherent in these huge profits is brilliantly illuminated and analyzed in two excellent articles.

In the first, Eric J.Fry raises several interesting questions, including the role played by the then US Treasury Secretary and ex-Goldman CEO, Hank Paulson, in setting the stage for Goldman's conquest and vanquishing of its Wall Street competitors. In well publicised back-room coups, Treasury Secretary enabled some financial firms to survive, forced others into the arms of unwilling saviors and allowed others to fall into bankruptcy.

Riasing sceptical eyebrows about the "capricious responses" of decision makers at the height of the crisis, which "enabled some financial firms to survive, forced others into the arms of unwilling saviors and allowed others to fall into bankruptcy", he writes,

"AIG survived, for example, and it promptly paid millions of dollars to Goldman Sachs to settle counterparty transactions. Lehman Brothers, on the other hand, died. Lehman’s elimination from the marketplace as a competitor bestowed an immediate and direct benefit to Goldman Sachs... the decision to let Lehman fail and to bailout AIG both emerged from the same closed-door meeting between Hank Paulson and various finance company CEO’s, including Goldman CEO, Lloyd Blankfein."

Since Bear Stearns and Lehman Brothers are gone, while Bank of America/Merrill Lynch, Citigroup, AIG and many other financial firms remain hobbled by their crippled balance sheets, all of Goldman’s former competitors are in no condition to compete. This has left the entire market open for Goldman's to conquer!

In an eviscerating and breathtakingly brilliant account of Goldman Sach's modus operandi, Matt Taibi (and here), writing in the Rolling Stone describes the world's premier investment bank as a "great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money". Describing Goldman as the best representative of modern day capitalism where "organized greed always defeats disorganized democracy", he writes,

"The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They've been pulling this same stunt over and over since the 1920s — and now they're preparing to do it again, creating what may be the biggest and most audacious bubble yet."

About its overarching reach, Taibi has this to say, "Goldman has its alumni pushing its views from the pulpit of the U.S. Treasury, the NYSE, the World Bank, and numerous other important posts; it also has former players fronting major TV shows. They have the ear of the president if they want it". He writes,

"The bank's unprecedented reach and power have enabled it to turn all of America into a giant pumpanddump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumercredit rates, halfeaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you're losing, it's going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where it's going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth — pure profit for rich individuals."

Taibi brilliantly explains (and here) the series of bubbles that Goldman has ridden on its way to profitting at the expense of everyone else. The list of other's misfortunes from which Goldman has profitted is impressive - Great Depression, tech stock boom of late nineties, housing bubble of early this decade, and the $4 a gallon oil of last year. And Taibi even prophesizes the next bubble waiting to happen (in the footsteps of the oil and commodities trading market) and one that Goldman has already rigged - carbon-credit market (thanks to the recently released draft bill on cap and trade)!

Even the devil has its defenders. Free Exchange makes a spirited defence of Goldman here and here.

Update 1
Janet Tavakoli writes,
"The biggest crime on the American economy may go unpunished with no consequences to the perpetrators. The biggest crime was not predatory lending, but predatory securitizations, packages of loans that did not deserve the ratings or prices at the time they were sold. They ballooned what should have been a relatively small problem into a global crisis.

Wall Street owes the American public for its key role in bringing the global economy -- and in particular, the U.S. economy -- to its knees. Goldman is not alone in owing the American public. It is not the worst of all of the Wall Street firms. But among all of Wall Street's offenders, it is the most well-connected, and Goldman was the firm that cleaned up the most as the result of government bailouts."

Update 2
Though Goldman benefitted greatly from the government's actions during the peak of the financial market crisis - removal of two of its biggest rivals, Lehman and Bear Sterans; the $13 billion in taxpayer money received as a result of the AIG bailout; federal debt guarantees; $ 10 bn TARP assistance (now returned); and permission at the height of the crisis to convert from an investment firm to a deposit taking national bank, giving it easier access to federal financing in the event it came under greater financial pressure - it is now claiming that it did not gain anything from the Government bailouts.

NYT as this excellent article analyzing the conflicts of interest facing Hank Paulson when he took major one-off decisions that benefitted Goldman.

Update 3
William Cohan has this list of Goldman executives who sold large chunks of stock in the dark days of 2008 in anticipation of a collapse in Goladman equity price.

Are small, local banks the solution for developing countries?

In the latest Economist Roundtable, Justin Lin Yifu, the Chief Economist at the World Bank argues that low-income countries (with economy reliant on small-scale manufacturing, farming and services firms) need to make small, local banks the mainstay of their financial systems. He feels that the size and sophistication of financial institutions and markets in the developed world are not appropriate in low-income markets. In other words, the structure of financial institutions and markets in many developed economies is inappropriate for many developing economies.

He draws attention to the experience of Japan, South Korea and China, which managed the transition towards higher income growth trajectory by adhering to "simple banking systems" (rather than rushing to develop their stockmarkets and integrate into international financial networks) and without liberalizing their capital accounts until they became more advanced. Even in the US, during the early labour-intensive phase of its economic development, local banks were dominant. Further, given the realtively mild effect of the financial crisis on America's large number of community banks, smaller banks are much more resilient when faced with such crisis. He writes,

"Microfinance companies and other non-bank financial institutions will play a more important role in financing poor households... stockmarkets are not the best conduit for providing finance to the small- and medium-sized businesses that characterise the early stages of countries’ economic development... gigantic banks... tend to serve relatively wealthy customers. Smaller domestic banks are much better suited to providing finance to the small businesses that dominate the manufacturing, farming and services sectors in developing countries... growth is faster in countries where these kinds of banks have larger market shares, in part because of improved financing for just these kind of enterprises."

He also points to the importance of instruments like credit registries (enable first-time entrepreneurs to document their personal credit histories and share them with lenders) and collateral registries (enable lenders to verify that assets such as property and vehicles have not already been pledged by the borrower to secure past loans) that lower transaction costs. Transparent and efficient court procedures to allow lenders to seize collateral, competition among small banks, and a regulatory framework that facilitate efficient exit and entry of banks are other important requirements.

Mark Thoma draws attention to the utility of sophisticated financial products like futures contracts and crop insurance to hedge price risk for farmers, and claims that a more appropriate model would be for the local banks to be embedded within a larger financial system so that the small banks can make available products that local banks cannot provide on their own. However, the problems of information asymmetry and difficulty in evaluating the risks of complex financial porducts, means that the markets should be regulated adeqautely and governments should themselves provide these financial products (like price guarantees for crops, crop insurance etc) wherever markets are likely to fail. He also writes that the local knowledge that allows local banks to assess the credit risks of individuals and firms more accurately should be preserved and made available system wide so that more comprehensive systems can emerge.

As Asim Khwaja writes, evidence that small, domestic banks have more smaller/local (profitable) clients and that growth is higher in countries with a greater share of small banks, does not conclusively prove that "small (banks) is better than big". There may be co-relations at work here - small, domestic banks may have more small clients simply because the larger banks have skimmed off the readily identified good borrowers (the large, established firms); higher growth countries may create room for more (smaller) banks and thus it is growth that produces an increase in the small bank share and not vice versa.

While advising the World Bank to avoid the area of banking and financial reform and focus instead on the more traditional anti-poverty projects, Tyler Cowen feels that if the larger financial institutions start to emerge naturally, from market forces, they should be encouraged.

Both Luigi Zingales, Ross Levine, Todd Moss, and Abhijit Banerjee stress on the importance of equity markets in mobilizing risk capital to fund new ideas and new ventures and promote entrepreneurship. Levine points to the need to "construct laws, regulations, and institutions that create a healthy environment in which financial institutions compete to provide the most useful credit, risk, and liquidity services to the 'real' economy" and thereby promote entrepreneurship, expand economic opportunities and lead to economic growth.

Banerjee also points to the examples of China, Taiwan and India which appears to suggest the inevitability of large amounts of loans getting written off and public monies ending up in private (or semi-private) hands, in the process of chaneling bank credit to smaller firms that would not have otherwise been seen as credit-worthy enough.

Banerjee also points to evidence in the context of bank lending to small firms that suggests that "large banks are less willing than small banks to lend to informationally 'difficult' credits, such as firms that do not keep formal financial records" They also find that large banks "lend at a greater distance, interact more impersonally with their borrowers, have shorter and less exclusive relationships, and do not alleviate credit constraints as effectively", and therefore favors small banks as being better able to collect and act on soft information than large banks.

Justin Lin also appears to have overlooked the several advantages that come with bigger financial institutions. Smaller local banks can compete with the branches of larger national banks, as is the case in India. Smaller banks are handicapped by their inability to assume larger risk due to their smaller portfolio and quantity of assets which limits their ability to diversify risks. As Abhijit Banerjee writes, they can become captive of a small group of investors or even non-investing political actors, who then use their leverage on the bank to steal the money of the depositors. Further, an increased number of smaller banks makes regulatory supervision more difficult to effectively enforce.

Sunday, July 19, 2009

Goldman Sachs signals Wall Street's return to risk taking

Bloomberg reports that Goldman Sachs'risk-taking has reached an all-time high in the second quarter, as equity bets increased 58% to amass record trading revenue and quarterly earnings. Its Value-at-risk (VaR), a measure of how much money the firm could lose in a day’s trading, rose to $245 million (at the 95th percentile, or a 5% probability that its portfolio would fall in value by more than $245 m over the day) from $240 million in the first quarter, and up from $184 million last May. Most of the increase during the second quarter stemmed from equity-trading risk, which surged to an average of $60 million per day from $38 million in the previous three months.

Quarter End Value-at-Risk Shareholder Equity
(Daily Average) (at Quarter End)

June 26, 2009: $245 million $62.81 billion
March 27, 2009: $240 million $63.55 billion
Nov. 28, 2008: $197 million $64.37 billion
Aug. 29, 2008: $181 million $45.60 billion
May 30, 2008: $184 million $44.82 billion
Feb. 29, 2008: $157 million $42.63 billion
Nov. 30, 2007: $151 million $42.80 billion
Aug. 31, 2007: $139 million $39.12 billion
May 25, 2007: $133 million $38.46 billion
Feb. 23, 2007: $127 million $36.90 billion

Goldman has been aided by the fact it enjoys a pile of blanket government debt guarantees, capital remains at historically cheap rates, and the market has been decimated leaving Goldman as one of the few players with the ability and appetite for risk taking. Further, a number of beleaguered financial institutions have been trying to leverage the government assistance to raise equity and other capital in the market, opening up large numbers of business (under-writing and other services) opportunities for investment banking majors like Goldman. On top of all these, the myriad government actions and bailouts of recent months have unmistakably signalled to the financial markets that the "too-big-to-fail" institutions, and there are none bigger than Goldman, will not be allowed to fail.

One of the criticisms of the regulatory regime in the build-up to the sub-prime crisis was the arguement that the non-depository institutions like investment banks and those in the shadow banking system assumed very risky positions using their proprietary capital and the regulators could nothing to control this. It was thought that the business model of investment banks, that relied on massive short-term leverage and making big investments with this borrowed money is bound to fail and carries unacceptable risks. In contrast, the capital requirements imposed on regulatory institutions enabled regulators to maintain some regulatory oversight on deposit taking banking institutions.

Now, with Goldman and its other major investment banking colleagues like Morgan Stanley becoming bank holding companies and thereby coming under the scanner of the Federal regulatory insitutions, it was hoped that their risk taking would be controlled. The dramatic recent increases in VaR appears to have belied such hopes and appears to have not had any effect on the firm’s appetite for wagering its capital on trading. Goldman's risk capital (or capital put at risk) has increased much faster than its capital has risen. In fact, Goldman has been allowed to assume its riskiest positions ever after it came into the formal ambit of the full Federal regulatory architecture!

As Felix Salmon puts it very appropriately, "I guess Goldman Sachs worked out how to generate profit growth in a world that no longer tolerates high leverage. It just increased the amount of capital it puts at risk every day." Two other nice articles analyzing Goldman's assuming of such huge risks are here and here.

It is being argued that the higher profits by Goldman Sachs, driven by its increased appetite for risk taking, reflected in its rising VaR, will force the other remaining big Wall Street into assuming more risks and thereby renewing the mad and unwinnable "risk" race that triggered off the sub-prime crisis in the first place. The low interest rates and the blanket government guarantees provides the ideal credit and financial environment for these institutions to assume large and cheap leverage positions, with potentially disastrous consequences for systemic risk. To this extent, Goldman may be exerting a hazardous negative externality on Wall Street!