Monday, May 31, 2010

Limits of modern macroeconomic models

In the last few days, the blogosphere has seen a fascinating debate about the effectiveness of macroeconomic models in explaining and forecasting economic events, triggered off by David Andolfatto's attack on Paul Krugman (Paul's precise response is here) and Brad DeLong's advocacy of fiscal policy measures to survive the recession. He had claimed that the policy advice of both was not based on an understanding of modern macroeconomic models and "rooted in rigorous theory", but went no deeper than the Keynesian cross.

This prompted an unexpectedly sharp retort from Mark Thoma who accused David of being "plain dishonest". He points to the recent works of economists like Gauti Eggertsson (a reduction in taxes on wages deepens a recession because it increases deflationary pressures, while a cut in capital taxes does the same because it encourages people to save instead of spend at a time when more spending is needed, and all this is of a higher magnitude when interest rates touch the zero-bound) Michael Woodford (welfare is maximized by expanding government purchases to at least partially fill the output gap that would otherwise exist owing to the central bank's inability to cut interest rates) and George Evans (also here), all of whose macro-models favor demand-side measures like aggressive fiscal policy interventions, especially when nominal interest rates are touching the zero-bound over supply-side measures like monetary policy actions or tax cuts.

He follows up with this excellent post where he feels that the standard macro model used for policy analysis, the New Keynesian model, is unsatisfactory in many ways and it may not be possible to fix it in a satisfactory enough manner.

Crucially, he feels that modern macroeconomic models do not generally connect the real and the financial sectors. These linkages assumes significance because they provide an important transmission mechanism whereby shocks in the financial sector can affect the real economy. Further, the representative (or identical) agent assumption, while it overcomes difficult problems associated with aggregating individual agents into macroeconomic aggregates, flies against the face of reality in modern day financial markets. He writes,

"When this assumption is dropped it becomes very difficult to maintain adequate microeconomic foundations for macroeconomic models... But representative (single) agent models don't work very well as models of financial markets. Identical agents with identical information and identical outlooks have no motivation to trade financial assets (I sell because I think the price is going down, you buy because you think it's going up; with identical forecasts, the motivation to trade disappears). There needs to be some type of heterogeneity in the model, even if just over information sets, and that causes the technical difficulties associated with aggregation."

In this context, in contrast to existing monetary policy rules, like the Taylor Rule, which are responsive only to inflation and the output gap, Mark Thoma points to recent research, by the likes of John Geanakoplos, in developing general equilibrium models of asset pricing in which collateral, leverage and default play a central role. As Rajiv Sethi writes, in these models,

"the price of an asset at any point in time is determined not simply by the stream of revenues it is expected to yield, but also by the manner in which wealth is distributed across individuals with varying beliefs, and the extent to which these individuals have access to leverage. As a result, a relatively modest decline in expectations about future revenues can result in a crash in asset prices because of two amplifying mechanisms: changes in the degree of equilibrium leverage, and the bankruptcy of those who hold the most optimistic beliefs."

Similarly, agent-based models which have been at the centre of the emerging field of complexity economics (which explores the interaction between economic agents under varying constraints and rules), may have an important role to play in the development of more real-world rooted macroeconomic models. More effective macroeconomic models will also have to incorporate the efforts of sometimes forgotten economists like Hyman Minsky. Rajiv Sethi has a few more suggestions to derive models which are better approximations of the real world.

See this and this for exhaustive coverage of the debates on the effectiveness of fiscal policy measures to combat recessions.

Update 1 (12/6/2010)

Edward Glaeser has an excellent post that highlights the problem with modern macroeconomics, in its ability to prescribe solutions for preventing and addressing banking crisis, economic crisis and high unemployment rates. To take the example of banking regulation, he writes,

"There is certainly a healthy debate about the appropriate nature of the remedy. Are higher capital requirements enough? Should banks be charged a risk tax based on their portfolios? Should the biggest banks be broken up so that they are no longer too big to fail?"

Update 2 (18/3/2011)

Greg Mankiw and Matthew Weinzierl argue that any optimal stabilization policy when the nominal interest rates are zero should revolve around commiting to increase inflation and cutting taxes. They note that tax policy can do a better job of replicating the flexible price equilibrium in terms of the allocation of resources, and hence tax policy should be used instead of government spending. See the critiques by Paul Krugman and Mark Thoma.

Sunday, May 30, 2010

Return of market volatility and threat to world economy?

There is a growing fear that the crisis in Eurozone will rock the global financial markets and drag the world economy into a double-dip recession. The financial markets have been spooked by the prospect of sovereign-debt defaults and fiscal austerity measures that could strangulate any signs of economic growth in these economies. The precarious nature of the US economic recovery, with its persisting unemployment challenge, and the growing uncertainty about China (coupled with its continued aversion to domestic consumption and reluctance to revalue yuan), means that the prospects in all the major engines of global economic growth in recent years does not look very bright.

The bellwether TED spread (difference between the three-month T-bill interest rate and three-month LIBOR) shows a clear rising trend since March.

The Economist has a series of charts that graphically illustrates the first signs of danger lurking ahead. After a spectacular rally since March 2009, equity markets across the world have started falling since April. This decline has mirrored similar falls in commodity and other asset prices.

After falling continuously for a year, the CBOE VIX is on the rise again. The Nifty-based India VIX too has been showing signs of heightened volatility.

In a reflection of the growing concerns about sovereign defaults in Euro-zone, despite the recent trillion dollar bailout, the CDS spreads have been rising steeply. Echoing the concerns in the credit markets and about health of the banking system, the rates in the inter-bank lending markets have been rocketing up.

Commodity prices and financial markets

One of the most interesting economic debates of the last few years has been that about the influence of financial market speculation on commodity prices. See here, here, here, here, and here. The sharp volatility in commodity prices, most spectacularly manifested in the case of oil, generated widespread scrutiny of activities in the commodities markets.

Economists like Paul Krugman pointed to the absence of any abnormal inventory build-up and backwardation (futures lower than spot prices) or weak contango (futures ruling higher than spot prices) in futures market prices, and rejected the speculation hypothesis and held the view that commodity price volatility was a reflection of underlying demand-supply conditions, especially in th emerging economies. However, others like Guillermo calvo and even the popular perception was that these price distortions were caused by the large investment flow to commodity indices - the total value of various commodity index-related instruments purchased by institutional investors increased from an estimated $15 billion in 2003 to at least $200 billion in mid-2008.

In this context, RTE points to a recent working paper, where Ke Tang and Wei Xiong have found that commodity prices have become increasingly co-related with one another and with stock prices. Examining the financialization process of commodities precipitated by the rapid growth of index investment to the commodities markets since the early 2000s, they write,

"We find that concurrent with the increasing presence of index investors, commodity prices have become increasingly correlated with the world equity index and US dollar exchange rate, and with each other. In particular, this trend is more pronounced for commodities in the two popular commodity indices, the Goldman Sachs Commodity Index (GSCI) and DJ-UBS indices. As a result of the financialization process, the spillover effects of the recent financial crisis contributed substantially to the large increase in commodity price volatility in 2008.

... while there was a small negative return correlation between the GSCI index... and the Morgan Stanley world equity index prior to the early 2000s, we find the emergence of an increasing trend in the correlation between the GSCI index return and the world equity index return, concurrent with the increasing presence of index investors in the commodities markets in recent years. There is also an intensifying trend in the negative correlation between the GSCI index return and the US dollar exchange rate in recent years. For individual commodities, we find that in recent years, their returns have become not only increasingly correlated with the world equity index and US exchange rate, but also with the oil return."

Saturday, May 29, 2010

Externality taxes should be large enough to be an effective enough deterrent

A tax on substances producing negative externalities is a well-established strategy to control its adverse effects. Accordingly, cigarettes and alcohol, have for long been the focus of attention of fiscal authorities, albeit more as a soft source of raising revenues than as an effort to curb adverse health and social externalities.

Amidst this, one of the less discussed issues have been the extent of taxes required to exercise a sufficient enough deterrent against their excess consumption. Econ 101 teaches us that if the price elasticity of demand for the product is low, then taxation will do little to reduce consumption and will only increase the prices paid by the consumers (since the incidence of taxation is higher on the price inelastic consumer). In the circumstances, for taxes to make a substantial dent on consumption, they need to be raised by a large enough percentage.

In this context, a recent RAND study that estimated the potential effect of soft drink taxes on 7300 children's individual-level consumption and weight by examining differences in existing sales taxes on soft drinks between states, and explored whether small or large taxes were more effective, comes to similar conclusions. They find that "existing taxes on soda, which are typically not much higher than 4 percent in grocery stores, do not substantially affect overall levels of soda consumption or obesity rates". They also find that "reducing consumption for all children would require larger taxes". The authors conculde that "Soda taxes do have the potential to help reduce children's consumption of empty calories and have an impact on obesity, but both their size and how they are structured are key to whether they create measurable impact."

Therefore as David Leonhardt writes in a Times article, "So a small soda tax could actually have a worse impact on some families’ budgets than a substantial one — by raising the price of soda without affecting consumption." He also has this superb graphic, which shows that soda prices have been declining since 1978 relative to overall inflation, as measured by the Consumer Price Index, with prices of carbonated drinks falling 34% relative to all other prices, largely because its cost of manufacturing has fallen dramatically. In contrast, the prices of the average real cost of fruits and vegetables has risen more than 30%.

This finding could have echoes in India too. Have prices of the median variety of cigarettes and alcohol risen slower than that of foodstuffs? Have the costs of producing the former fallen faster than that of producing food? If either are true, and my guess is that they are, then taxes on cigarettes and alcohol should be raised even more so as to exercise a large enough deterrent impact on its regular consumers.

Update 1 (6/6/2010)
Greg Mankiw does not support soda taxes, citing the slippery slope arguement (that such paternalism that seeks to protect us from ourselves can lead to undesirable outcomes).

Update 2 (18/6/2010)
David Leonhardt points to a study published in the American Journal of Public Health which finds sales of sugary soft drinks declined by 26 percent following a price increase of 45 cents — or 35 percent of the baseline price, a clear indication that when the price of soda goes up, consumption goes down. The same has been found true for both tobacco and alcohol.

Update 3 (23/6/2010)
Freakonomics points to a study by Tammo H.A. Bijmolt, Harald J. van Heerde, and Rik G.M. Pieters that have found that consumption of all goods in general drops by about 2.6 percent for every 1 percent increase in price. However, in view of its addictive power, alcohol use is much less responsive to prices, as shown by this review of 132 papers on the topic by Craig A. Gallet, who reported the average study showed that alcohol consumption, over the long term, drops only 0.82 percent for every 1 percent increase in prices. Cigarettes sales are even more insensitive to price hikes.

Update 4 (24/8/2012)

Kevin Callison and Robert Kaestner examined recent, large tax changes, which provide the best opportunity to empirically observe a response in cigarette consumption, and employed a novel paired difference-in-differences technique to estimate the association between tax increases and cigarette consumption. They find,
Estimates indicate that, for adults, the association between cigarette taxes and either smoking participation or smoking intensity is negative, small and not usually statistically significant. Our evidence suggests that increases in cigarette taxes are associated with small decreases in cigarette consumption and that it will take sizable tax increases, on the order of 100%, to decrease adult smoking by as much as 5%.

Friday, May 28, 2010

Property rights and Chinese economic growth

Two recent articles about China, one in Bloomberg on ambitious plans by Chongqing municipality (with population of 30 m) to spend 1 trillion yuan ($147 bn) on infrastructure and property projects to bolster economic growth, and another in the Times chronicling the excesses involved in its urban re-development projects have great relevance for India.

The Chongqing municipality's plans covering 323 projects, including construction of the world’s tallest twin towers, two-thirds of which will be financed by government, will be completed in 3-4 years. Further, it is part of a more ambitious five-year plan, starting 2011, to spend upto 2 trillion yuan on "key projects".

It is estimated that land (local government control much of the land) sales provide up to 60% of local government revenues and in its 70 biggest cities, government land-sale revenues leaped 140% in 2009, to $158.1 billion. Local governments have reaped huge profits — up to 100 times the compensation amounts — by such commercial re-developments and sales. With land sales and commercial sales being amongst the largest sources of incomes and a critical engine of growth, local governments have played a major facilitatory role in keeping the property bubble inflated.

The existing loophole-ridden land rules, dating from 2001, give governments and private developers wide leeway to clear property and settlers are ousted from their homes with cut-rate compensation and scant legal recourse. As the Times reports, local governments pick renewal sites at will; leave negotiations with residents to developers, demolition companies and low-level 'demolition and relocation offices'; low-ball home-purchase offers; cut off utilities; and even hire gangs of thugs to terrorize homeowners.

A series of protests and immolations forced Beijing into passing a legislation two years back to strengthen individual property rights in cities and regulations on dispossession from urban lands, though it has not yet been translated into rules. The draft rules require developers and officials to consult homeowners, pay market rates for homes and put off demolition until sales and relocation details are settled — and, sometimes, approved by two-thirds of homeowners. It also would prohibit governments from forcibly seizing homes, in a process akin to condemnation in the United States, without specific 'public interest' purposes.

Arguably two of the biggest challenges facing the infrastructure sector in India are those relating to mobilization of financial resources and accquisition of land for project implementation. China enjoys inherent institutional advantages in both these areas - since most land is government owned, it can be sold away or developed to raise resources, and the political system ensures that all opposition to the exercise of government's powers of eminent domain are easily swept away.

An apple to apple comparison of India and China would involve calculating growth rates after controlling for these two factors. What would have been the trajectory of Chinese economic growth in the absence of government ownership of property and stronger political and property rights?

Update 1 (2/6/2010)
See Mathew Yglesias here.

Update 2 (25/7/2010)
See this NBER working paper on Chinese urban land lease auctions.

Update 3 (31/7/2010)
Yongheng Deng, Joseph Gyourko, and Jing Wu (bigger pdf article here) claim that a housing bubble may be developing in China. Chinese government still owns all the land in urban areas and leases its use for long periods of time. The major contributing factor to the increase in land prices have been the massive purchases by government agencies, flush with funds and access to capital at cheap rates. The graphic below is the constant quality price index for newly-built private housing in 35 major Chinese cities, 2000-2010

Update 4 (2/8/2010)
Land records show that 82 percent of land auctions in Beijing this year have been won by big state-owned companies outbidding private developers — up from 59 percent in 2008. Land prices in Beijing had jumped by about 750 percent since 2003, and that half of that gain came in the last two years.

Last year, state banks made a record $1.4 trillion in loans, nearly twice as much as the year before. Analysts say they believe much of that money was diverted into the property market through off-balance-sheet maneuvers, leading to the record land bids and soaring property prices. A growing number of municipalities have formed local investment vehicles that borrow heavily from state-owned banks (local governments cannot directly borrow from banks or issue bonds for real estate development) to pay to relocate residents and build infrastructure around big plots of land they intend to sell at auction.

Thursday, May 27, 2010

Individual choice Vs transaction costs

One of the most enduring debates in public policy making is in achieving the right balance in providing the widest possible individual/consumer choice without creating unscalable transaction costs in the individual making the most optimum choice. Daniel Hamermesh has this insightful paragraph in the Freakonomics blog about how the individual choice-transaction costs trade-off can often get skewed in favor of the later.

"US bureaucracies seem more flexible than the ones I’ve dealt with in wealthy foreign countries. On the other hand, much less seems to be taken care of for the average citizen in the US than elsewhere — it requires tremendous knowledge and investment of time to get the best deal out of health insurance, Social Security and so many other publicly - or commonly-provided benefits. In wealthy foreign countries, the average citizen is not at much of a disadvantage compared to a knowledgeable, wealthier citizen. In the US, I wonder how the average guy can cope with institutions (or if he can). As in so many areas, we Americans have created a system that allows great flexibility, but that also advantages the better-off. Have we made the right choice in this apparent trade-off?"

These transaction costs arise from two directions

1. Making the most optimal choice from the bouquet of choices presupposes the presence and application of sufficient prior knowledge, both about the general environment and the specific sector, in the individual making the choice. Most often such prior knowledge is a function of the socio-economic status of the individual (which in turn is not fully determined by factors within the control of the individual).

2. Behavioral economists point to Propsect theory and the paradox of choice and the difficulty humans face in making the complex calculations required to make the most optimal choice from among a large number of competing choices.

Therefore, the most under-privileged people who make these choices (and for whom these choices matter the most) do not have adequate prior knowledge and also suffer from the behavioral cognitive biases that constrain them from making efficient choices. It is for this reason that despite, its paternalistic overtones, I am favorably disposed towards the "nudge"-based "liberatarian paternalism" (see this essay examining the new paternalism). This is also a note of caution against blind advocacy of unfrettered consumer/citizen choice in the belief that market dynamics will ensure that the most optimal choices are made.

Tuesday, May 25, 2010

Eurosclerosis - the role of demography and welfare state

The blame game for the crisis in Euro zone goes on. This has become yet another opportunity for closet free-marketers (who had been briefly silenced in the aftermath of the sub-prime crisis) to question the sustainability of the European model of social democracy (with its generous vacations, early retirements, national health care systems and extensive welfare benefits) and proclaim the relative superiority of American capitalism. This triumphalism comes despite America facing massive problems of much the same kind and magnitude as Europe - unsustainable fiscal and current account deficits, burgeoning debt stocks, aging populations, frozen credit markets and anemic economic growth environment. Further, on critical areas like limiting job losses and cushioning against the adverse impacts of the depp recession, Europe appears to have done far better than the US

Amidst all the explanations for the problems that afflict the Eurozone, one cannot but help not notice certain similarities between it and rest of the advanced economies, mainly the United States. Despite the slight variations in the depths of their recessions, fundamentally all have couple of underlying socio-economic characteristics - one, the steep increase in debt burdens in recent years, and second, the aging demographic profile of national populations which significantly distorts the financial dynamics of the generous existing welfare system.

The massive debt stocks and persistent deficits (internal and external) coupled with recession will ensure that the share of public debt relative to the GDP will continue to rise. The aging demographic profile will only increase the upward pressures on government expenditures. In the circumstances, there are only two options - either cut down on other expenditures or increase taxes. However, the magnitude of the deficits are so large that merely tinkering with conventional expenditure cutting areas like defense and welfare will yield limited results. This leaves governments with no alternative but to raise taxes steeply apart from indulging in all the conventional expenditure control measures.

However, as Peter Boone and Simon Johnson show with the example of Ireland, such interventions to both cut expenditures and raise taxes come with considerable costs and even threatens to drag the economy into a deeper hole. Despite the tough fiscal austerity measures (by slashing public sector spending and freezing wages for government employees) and tax increases since spring 2009, the European Commission estimates that Ireland will have one of the highest budget deficits in the world at 11.7% of GDP in 2010. Such countries face fiscal problems from both directions - "when you cut spending you also lose tax revenues from people who earned incomes from that money" and "the newly unemployed seek benefits, so Ireland’s spending cuts in one category are partly offset by more spending in another".

Adverse demographics in the shape of an aging population and resultant fiscal strains to support the same level of welfare benefits forms the second leg of the problems facing these countries, with the Eurozone countries being the worst affected. A series of excellent graphics captures the true extent of the demographic challenge and the resultant pension problems facing advanced economies.

The first graphic best captures the gravity of pension crisis facing the advanced economies - the numbers of workers supporting a retired person is projected to decline dramatically. In the 1950s while there were around 7 workers on average for every retiree in OECD countries, it had fallen to 4 to 1 by 2010, and is projected to fall to just 2.2 to 1 in 2040.

The graphic on legal retirement age and effective age of exit for the active population, 2002-2007, shows that France stands out among all its OECD partners.

As a corollary, the amount of time people spend in retirement is over 20 in most OECD countries, with France naturally topping, as the graphic below of the estimated years in retirement, by sex, 2007 shows.

Forecast indicate that the cost of public pension systems will keep rising. Whereas, in 2007 public spending on pensions accounted for 10% of GDP in the European Union, it is estimated to rise to 12.5% by 2060.

Public transfers form a disconcertingly large share of people's retirement incomes in most OECD countries.

As a reflection of these growing problems, a recent Times op-ed reported that gross public social expenditures in the European Union increased from 16% of GDP in 1980 to 21% in 2005, compared with 15.9% in the United States. In France, the figure now is 31%, the highest in Europe, with state pensions making up more than 44% of the total and health care, 30%. Further, only half the people above 50 work, compared to 7 out of 10 in others like Sweden and Switzerland, and the legal retirement age is 60. The French state pension system today is running a deficit of 11 billion euros, or about $13.8 billion; by 2050, it will be 103 billion euros, or $129.5 billion, about 2.6 percent of projected economic output.

The US too faces much the same problems with its rapidly aging population. As Bruce Bartlett explains, pointing to a Census Bureau report, that an aging population may make it even harder, politically speaking, to cut benefits like Social Security. The census estimates that while 27.1% of the population is currently under age 20, 59.9% is between 20 and 64, and 13% is 65 or older, by 2020, the under-65 share will fall by 3.1% and the 65 and over share will rise to 16.1% of the population. In raw numbers, the number of those 65 or over will rise by 14.5 million persons.

Update 1 (26/5/2010)
In response to the crisis, many European countries have announced fiscal austerity plans, mainly freezing or cutting public-sector pay, increasing retirement ages and reversing temporary tax breaks and other cushions that were encouraged in 2008 and 2009 to help beat back the worst recession in decades. These spending cuts when fiscal expansion is the need of the hour have raised fears about the possibility of these economies being dragged into a deeper recession.

Italy announced that it would cut its budget deficit to below 3% of GDP by 2012, from 5.3% last year, through cuts to public spending, and reducing the costs of politics and public administration, while pledging a more concentrated crackdown on tax evasion and on people fraudulently collecting disability pensions. Pay for civil servants would be frozen for three years, top-level civil servants’ wages would be cut and the retirement of state employees would be delayed. It however has said there would be no new taxes or raising of existing taxes.

Greece has already announced increasing the broader retirement age to 65 and cutting public salaries to bring the deficit down from the current 13.6% GDP to less than 3% in 2014. Spain has announced pay cuts of about 5% for civil servants — and 15% for government ministers — as well as other measures totaling 15 billion euros, besides reversing a previous decision to increase pensions next year and scrapping a subsidy of 2,500 euros for new parents. Portugal has announced plans to cut its deficit faster than planned, to 4.6% of GDP next year from 9.4% last year. They have already declared on tax increases and cuts in public-sector wages and corporate subsidies.

The new British government has declared that it would push through £6 billion ($8.65 billion) in spending cuts in an effort to convince skittish markets that the new government led by David Cameron was committed to fiscal restraint. More detailed cutbacks are expected in a new budget next month.

Monday, May 24, 2010

Free markets and health care policy

Health care in general, and health insurance in particular, have been described as classic examples of sectors rife with market failures. One of the best examples of this is the challenge facing government hospitals across much of developing world in their efforts to fill up large numbers of doctor vacancies in the face of competition from private hospitals.

The Times reports that China too is facing problems arising from doctors preferring the tertiary hospitals in large towns, thereby causing impoverishment of the primary and secondary hospitals in small towwns and villages.

In countries like India and China, which produce a few thousands of doctors every year, merely liberalizing private investments in health care without simultaneously strengthening the existing government primary and secondary health care facilities is a recipe for disaster.

In the absence of a strategic policy framewrk, the large numbers of corporate hospitals that continue to proliferate "crowds out" all the best doctors from the government health care system. This "crowding out" effect works in many dimensions

1. The older doctors in the government medical colleges, especially the most reputed ones, are incentivized to join corporate hospitals with handsome salaries (shares in each patient treated).

2. The newly graduated doctors, for whom the alternative is to either join a medical college or the primary health care hospitals as junior doctors (with attendant consequence of working in small towns and villages), the attraction of the large salaries and choice of staying on in the larger towns, is often irresistable.

3. Some older doctors who stay on in government hospitals consult part-time for the private hospitals. Some even have their own clinics. The result is reduced incentives to work sincerely in their government posts and even siphoning off of patients to the private hospital.

4. All the aforementioned effects are highly pronounced for specialists, whose scarce numbers (both existing ones and fresh graduates) cannot meet the massive demand in both government and private hospitals. In the competition for procuring the services of specialists, the private hospitals trumps the government ones with their much higher salaries and more flexible terms of employment.

5. The government hospitals are finally left with doctors who have not received offers from the private clinics (presumably because they are not considered as efficient or qualified as their peers who were offered jobs). Since the better doctors do not stop with the basic degree and work towards acquiring specialist skills, only those with the basic degree (and without the talent/opportunities to acquire the specialist skills) are left in the government system.

In other words, in a free labor market for doctors, the incentives are inherently structured such that the private hospitals end up displacing a large number of good doctors from the government hospitals and also "crowding-in" the better among the fresh graduates.

What is the policy framework that can regulate this "crowding out" so as to retain the effectiveness of government hospitals without adversely affecting the quality of private hospitals? Though arriving at the most effective mix of policies is a massive challenge, I will try to examine some of the possible solutions in forthcoming posts.

Sunday, May 23, 2010

Financial market regulation proposals update

Mike Konczal has an excellent summary of all the various financial market regulation proposals under discussion in the US. They include the House and Senate versions of the Financial Market Regulation Bill and President Obama's White Paper. The graphics below compares each of the three proposals with a "healthy markets" proposal with respect to

1. Consumer financial protection (independence Vs transparency)

2. Derivatives and shadow banking sector reform (levels of systemic risk Vs transparency)

3. Creation of a resolution authority (detection Vs deterrence)

4. Overall assessment of the pro and cons of the three proposals (levels of regulation Vs transparency)

About the resolution authority, the newest dimension to the debate comes in the form of "living wills" from Alan Greenspan's elaborate explanation fo the sub-prime crisis cum defense of his actions as Fed Chairman. He has proposed "living wills" for all financial intermediaries where they publicly disclose (thereby pre-empt counterparties from complaining after the fact that they thought they had more legal rights in the event of liquidation than they do) their own plans to wind down in the event that they fail, thereby leaving policymakers with a a game plan in hand if these instiutions fail.

This would essentially mean, as Economics of Contempt writes, "Instead of providing a plan for the financial institution's own resolution, we should instead use living wills as a way to force financial institutions to provide regulators with all of the information they'd need to actually carry out a rapid and orderly resolution." However, as it writes, relying on the financial institution to submit a plan for their own resolution may not be a good idea, especially given the moral hazard generated by the recent experiences.

In an excellent post, Mark Thoma makes the point that while reducing the size of banks is important from a political economy perspective, and also from a market power perspective, we will also need to have leverage limits, limits on connectedness, limits on the concentration of risks, etc. He argues that while it may be impossible to guarantee against another financial bubble blowing up, these restrictions can make it harder for bubbles to inflate.

Taking forward Mark Thoma's arguement, the utility of such restrictions may not be so much in eliminating bubbles (which will continue to get inflated nevertheless), but as in minimizing the damage due to these bubbles and in making it easier to clean up afer the bubbles bursts.

See also Steve Waldman who writes, "totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured... 'Large complex financial institutions' report leverage ratios and 'tier one' capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15X, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish 'well capitalized' from insolvent banks, even in good times, and regardless of their formal statements."

See also this debate on the Dodd Bill currently under discussion in the US Senate. Simon Johnson feels that the Bill misses a huge piece without any provision for a cap on size. Mark Thoma agrees with Simon Johnson, but argues that small banks with inter-connected risks could pose just the same problem. He also proposes leverage restrictions, at say 15:1.

Two days back, the US Senate finally passed its version of financial reform bill, sponsored primarily by Senator Christopher J. Dodd. It would seek to curb abusive lending by creating a powerful Bureau of Consumer Protection within the Federal Reserve to oversee nearly all consumer financial products; to ensure that troubled companies, no matter how big or complex, can be liquidated at no cost to taxpayers; empower regulators to seize failing companies, break them apart and sell off the assets, potentially wiping out shareholders and creditors. It would also create a “financial stability oversight council” (composed of the Treasury secretary, the chairman of the Federal Reserve, the comptroller of the currency, the director of the new consumer financial protection bureau, the heads of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation, the director of the Federal Housing Finance Agency and an independent appointee of the president) to coordinate efforts to identify risks to the financial system; establish new rules on the trading of derivatives and require hedge funds and most other private equity companies to register for regulation with the Securities and Exchange Commission; and force big banks to spin off some of their most lucrative derivatives business into separate subsidiaries.

The Bill also seeks to impose a thicket of rules for the trading of derivatives, and with limited exceptions, derivatives would have to be traded on a public exchange and cleared through a third party. Further, some of the biggest banks would be forced to spin off their trading in swaps, the most lucrative part of the derivatives business, into separate subsidiaries, or be denied access to the Fed’s emergency lending window. Features of the Senate Bill and a comparison with the House Bill are available here and here.

Update 1 (30/5/2010)
Economist has this comparison of the Senate and House versions of financial market regulation proposals.

Update 2 (1/6/2010)
Michael Lewis has this superb parody op-ed on financial market regulation proposals and what Wall Street should be doing to defeat them.

Update 3 (26/6/2010)

The US financial market regulation proposals come one step closer to adoption, as the members of the House-Senate committee arrived a mutually agreeable set of proposals from their respective bills. They include restrictions on trading by banks for their own benefit and requiring banks and their parent companies to segregate much of their derivatives activities into a separately capitalized subsidiary.

On the Volcker Rule which limits banks in making their own investments or putting money in hedge funds, the compromise proposals would bar banks from some kinds of speculative investing, but still can invest up to 3% of their equity in hedge funds and private equity funds. See this, this, and this on the bills.

Edmund Andrews has a nice summary of the proposals - The bill would give the government new power to oversee systemic risk and to shut down giant failing institutions (another AIG) in an orderly way. It includes a surprisingly strong “Volcker Rule,’’ which almost prohibits banks, with their federally-insured deposits and special access to Fed borrowing, from engaging in proprietary trading. It sharply restricts the ability of banks to trade derivatives. It cleans up the whole business of derivatives by moving the trading into clearinghouses and onto exchanges where it will be transparent and properly capitalized. And it creates a new consumer protection agency, albeit within the Federal Reserve, with the power to crack down on shady mortgages, credit card practices, payday lenders and other financial services.

Friday, May 21, 2010

Tar sands as the oil source of the future

The huge environmental disaster surrounding the leakages from BP's off-shore drilling platform Deepwater Horizon in the Gulf of Mexico has again focussed attention on alternative sources like the oil (or tar) sands that lie underneath the sub-arctic forests of western Canada. Buoyed by the "sweet spot" of reasonably high plateau that oil prices have reached in recent years and declining or stagnant production, hitherto expensive oil sources like Canadian tar sands have suddenly become attractive.

Canada has 178 billion barrels of proven oil reserves, higher than all except Saudi Arabia, annd virtually all of it is under tar sands. The United States produces about five million barrels of oil a day and imports 10 million more, of which Canada accounts for about 1.9 million barrels (and roughly half of it from oil sands).

The Times reports that though it is far safer to extract oil from underneath the tarry rocks (in comparison to the deepwater oil rigs), such exploration poses other environmental challenges, like toxic sludge ponds, greenhouse gas emissions and the destruction of boreal forests. Most of the biggest production sites are huge mine pits, accompanied by ponds of toxic waste; extraction from under tar sands produces far more greenhouse gases than conventional drilling; the process requires three barrels of water for every barrel of oil produced because the dirt must be washed out (already tailing pools cover 50 square miles of land abutting the Athabasca River); and the mines are also carving gashes in the world’s largest intact forest, which serves as a vital absorber of carbon dioxide and a stopover point for millions of migrating birds. However, while acknowledging the dirtiness of the current extraction process, supporters point to the emergence of more efficient and environment friendly extraction technologies.

The uncertain geo-politics of Middle Eastern oil coupled with the deep concerns about off-shore exploration due to the recent BP incident, has already made Canadian tar oil politically attractive in the US. Further, the heavy oil from Venezuela and Mexico are increasingly becoming more expensive to refine and therefore costlier.

The massive tar sands reserves is another blow against the oft-repeated "peak oil" hypothesis which claims that oil exploration has reached its highest point and can only decline from now. It is also yet another reminder of the fact that as technology advances and the economics of exploration becomes favorable (as existing sources get depleted), hitherto unviable sources start becoming attractive. The tar sands may only be following the recent example of natural gas where breakthroughs in extracting gas trapped underneath hardy shale-rock formations that have given a big boost to its exploration.

What links cows and datacenters?

Researchers at HP claim that "America’s dairy farmers could soon find themselves in the computer business, with the manure from their cows possibly powering the vast data centers of companies like Google and Microsoft".

According to HP’s calculations, 10,000 cows could fuel a 1 MW data center, which would be the equivalent of a small computing center used by a bank. Going one step further, they also claim that the heat produced by data center equipments could also be used to power biogas plants which require heat.

Thursday, May 20, 2010

Mobile phones as personal ATMs?

It has been very obvious for sometime that mobile phones have the potential to be the game-changer in promoting digital financial transfers by both lowering costs and user-inconveniences and more importantly, by dramatically expanding access among people without formal banking accounts.

Mobile phone-based payments are also expected to also revolutionize the way in which governments can transfer subsidies to targeted beneficiaries, including making activity-based micro-payments. Besides, it will be a boon for small businesses who had been disadvantaged by their inability to accept card-based payments.

The Times reports that several companies (like eBay’s PayPal unit, Intuit, VeriFone and Square) have developed small credit card scanners that plug into a cellphone and for a small fee enable any individual or small business to turn a phone into a credit card processing terminal. PayPal’s cellphone application calls for only a simple bump of two cellphones to transfer money.

The technology being used by the likes of eBay will involve the direct involvement of both the credit card companies and the cell-phone providers. The former will use the cell-phone as the gateway to access the individual accounts. This is in contrast to the digital payment model based on simply swiping cell-phones equipped with digital wallet interfaces against readers, developed by Visa jointly with phone manufacturers, which has been very popular in Japan since 2006.

But, the substantial transaction fees charged by both the mobile operators and credit card companies mean that it will be sometime before such transactions can catch on in a big way.

Further, as I have already blogged elsewhere, such readily accessible payment sources also increases the possibility of self-control problems that could adversely affect the spending and savings habits of people, especially poor people.

Apart from improving access to the formal banking sector, mobile phones could have an even bigger impact in the monitoring of the delivery of various welfare services and in delivering customized micro-information on a real-time basis. For example, attendance of teachers in schools and doctors/nurses in hospitals could be taken using GPS enabled mobile phones (which can capture co-ordinates of the location) or 3G phones (which can photograph locations). Further, ANMs in the field could be informed details about their daily ante-natal and immunization targets (details of the individuals and the services to be administered).

See also an ICRIER working paper by Surabhi Mittal, Sanjay Gandhi, and Gaurav Tripathi (pdf here, via Amol Agarwal) that explores the utility of mobile phones in agriculture. Mobile phones can deliver highly customized real-time information about inputs, credit, weather, storage facilities, price trends, and extension services that can enable farmers to maximize their productivity and optimize returns. The report also claims that mobile phones can play a critical role in increasing market efficiency and reducing price dispersions in agricultural markets.

Update 1 (24/3/2011)

NYT article on the developments in the usage of mobile phones as wallets. Wide adoption of the so-called mobile wallets is being slowed by a major behind-the-scenes battle among corporate giants - mobile phone carriers, banks, credit card issuers, payment networks and technology companies are all vying to control these wallets.

Update 2 (20/9/2011)

Google launched its Wallet service for making one-tap payments with a mobile phone using Nexus S 4G phones on Sprint’s network in the US. The Wallet is an app that links to a near-field communication (NFC) chip inside the phone. The technology allows the handset to make a payment by simply tapping on a reader in a shop. The service will use an existing payment gateway of Visa or Mastercard to transact the payments.

Google has thereby moved ahead of a similar joint venture called Isis, set up by the AT&T, T-Mobile and Verizon mobile operators.

Update 3 (19/7/2012)

NYT points to a new iPad application developed by Square that helps you pay your bills by merely repeating your name. See also this.

Wednesday, May 19, 2010

Incentive distortions in financing power projects

Businessline reports of a new trend in financing power projects, wherein power equipment manufacturers, power trading companies, and O&M contractors have been "sweetening their pitch for contracts by offering to contribute equity stakes in upcoming projects". However, despite its obvious attractiveness for both developers and equity investors, this trend opens up several opportunities for conflicts of interest and incentive distortions.

Equity participation becomes attractive for cash-strapped promoters, especially state generation companies (from Maharashtra, Tamil Nadu, and Karnataka), in achieving financial closure. Manufacturers, traders and contractors see equity participation as a backdoor to bagging contracts.

Assuming that promoters' investment decisions, on both capital and technology, are always driven by profit and efficiency maximization, the aforementioned model creates possibilities for incentive distortions that goes against these objectives. Here are three possible such conflicts of interest

1. Equity contributions by manufacturers have the potential to distort equipment and technology specifications (as the equity investing manufacturer tries to influence the bidding process to his advantage), and in the process result in sub-optimal investment decisions. Given the 80:20 debt-to-equity ratios in power projects, manufacturers see a small equity stake as a cheap way to bag massive contracts.

2. Power traders with investments in generators have an incentive to selectively restrict generation/supplies and thereby create artificial shortages, so as to inflate prices.

3. O&M contractors with equity investments have an incentive to get contract provisions incorporated that are not necessarily in the interest of the project.

It is therefore imperative that the Central and State regulatory commissions take appropriate measures to curb such conflicts of interests. But, whatever the precautions incoporated into contract provisions, through regulatory directions, to pre-empt these perverse incentives, it is impossible to fully eliminate them.

More on impact of fiscal stimulus

Latest addition to the fiscal stimulus impact literature comes from an excellent survey by the IMF.

The paper studies the short-run economic impact (or size of fiscal multipliers) of temporary government fiscal policy actions in lessening the depth and duration of the slowdown, using seven commonly used structural models of national economies and global economy. In view of the fact that these models are designed for normal situations when central banks undertake monetary contraction in the aftermath of a fiscal expansion to pre-empt inflationary pressures, the authors explore an extra dimension by examining the impact of fiscal stimulus when the central banks follow a policy of monetary accommodation. They conclude,

"There is no such thing as a simple fiscal multiplier. The size of the response of the economy to temporary discretionary fiscal stimulus depends on a number of factors, including most importantly the type of fiscal instrument used and the extent of monetary accommodation of the higher inflation generated by the stimulus. Temporary expansionary fiscal actions are most effective when the fiscal instrument is spending or well-targeted transfers, and when in addition monetary policy is accommodative. On the other hand, permanent stimulus, that is a permanent increase in deficits, is much more problematic than temporary stimulus. It leads to a long-run contraction in output, but in addition it substantially reduces short-run fiscal multipliers. Finally, the G20 stimulus should have significant effects on global GDP in 2009 and 2010."

The graphics below captures the relative impacts of various fiscal interventions in the US and Europe (as estimated by different ageencies/models) over time, with varying years of monetary accomodation.

1. Impact of targeted transfers (is very effective with extended monetary accommodation)

2. Impact of labor income tax (has minimal impact)

3. Impact of corporate income tax (has the least impact, even with monetary accommodation)

4. Fiscal stimulus impact on real GDP across the world

Monday, May 17, 2010

A synchronized debt cycle among developed economies

Carmen Reinhart and Ken Rogoff have shown that sovereign debt build-up has been a recurrent theme among national economies throughout history. However, "this time may be different" given the appearance (as the graphic below suggests) of a global debt cycle across most developed economies. Or is it?

The graphic above, which maps the medium term deficits as percentage of GDP, excluding interest payments and assuming unemployment drops substantially to full employment, shows that most developed economies will have cyclically adjusted primary deficits. It also claims that the "finances of the advanced economies are in a worse state than at any point since the industrial revolution".

Here are two specific reasons why developed economies have been uniformly piling up debts in this remarkably co-ordinated global debt cycle.

1. Globalization and more importantly, global financial market integration, may have had the effect of dramatically synchronizing individual business cycles of nations or regions, into one big global business cycle. This may have contributed towards a more or less synchronized debt build-up amongst the developed economies.

2. Over the last decade or so, much of the developed world has uniformly experienced an era of remarkably low real interest rates. Both the nominal rates and inflation have remained stable at very low levels. This in turn encouraged economies and businesses to load up on debt.

Given the fact that this debt cycle has coincided with economic weakness in all these economies, even the medium-term prospects of a recovery from this debt spiral (through buoyancy in revenues and a fast enough increase in the GDP) does not look promising. Further, the recession may have ended up amplifying the deficits. As long as interest rates remain low, the debt servicing burdens will remain manageable.

But how long can the markets be kept under the illusion that recovery is round the corner and these economies remain credit-worthy? As the recent events in euro zone shows, one wild enough market destabilizing event is enough to drive up the bond spreads and wreck economies.

Sunday, May 16, 2010

Is the recession driving the debt burdens?

The synchronized global business cycle has meant that all the major economies look set to face a long period of weakness. In a recent post, Economix pointed to a graphic (from an IMF report) which indicates that the dramatic increases in public debts across the developed economies is driven mostly by the output collapse and the related revenue loss.

Of the almost 39 percentage points of GDP increase in the debt ratio, about two-thirds is explained by revenue weakness and the fall in GDP during 2008-09 (which led to an unfavorable interest rate-growth differential during that period, in spite of falling interest rates). Interestingly, the IMF report estimates that the fiscal stimulus contributed to only one-tenth of the increase in debt. Much the same story comes out from an examination of the sources of the massive $1.2 trillion US fiscal deficit.

Political trilemma of the world economy?

Dani Rodrik has an interesting article while tries to explain the problems facing the euro zone in terms of the "political trilemma of the world economy", which he defines as

"Economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push for globalization while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalization, we must shove the nation-state aside and strive for greater international governance."

As recent events have shown, in the absence of political union (thereby permitting labor mobility, fiscal transfers etc), one of the biggest deficiencies with the Euro project is that it does not provide for an agency that can stabilize the business cycle across member states by either making fiscal transfers or serving as lender and insurer of last resort.

"The crisis has revealed how demanding globalization’s political prerequisites are. It shows how much European institutions must still evolve to underpin a healthy single market. The choice that the EU faces is the same in other parts of the world: either integrate politically, or ease up on economic unification."

I am inclined to the view that Dani may be going against his own "many recipes" line of narrative building by making this sweeping conclusion. A more appropriate phrasing of the trilemma may be that the processes of economic globalization and political democracy and the institutions of the nation state interact with each other in a dynamic manner and it requires a careful (and context-specific) accomodation among the three to successfully manage the political economy. In realpolitik terms, a balance of power among the three will have to be established.

Primarily, national sovereignty as we have known it will surely have to step down from its pedestal of supremacy and accomodate the forces of economic globalization. The globalized nature of many economic processes and business activities means that the nation state can no longer effectively regulate the various externalities that arise from them. The last few decades have seen the emergence of a number of supranational regulatory agencies - which aggregate some of the traditional sovereign powers of nation states - in areas like financial market transactions, international trade, counter-terrorism, environmental issues etc.

The situation of this narrative in the context of euro-zone crisis is misleading in so far as EMU is an explicit attempt at the creation of a trans-national agency, which seeks to aggregate some of the most fundamental sovereign powers (like issuing currency and framing monetary policy) of member states, to manage their macroeconomic environment. The major failing of the Euro project has been its inability to strike the right balance between the trilemma, more specifically between the powers of the nation state and the requirements of economic globalization among member states of the Eurozone. In other words, it is not a manifestation of an "impossible" trilemma, but an example of the collapse of balance of power within the trilemma.

Saturday, May 15, 2010

Pricing distortions in the iron ore market

The three big iron ore mining companies - Vale (16.6% in 2008), Rio Tinto (10.8%) and BHP Billiton (7.2%) - dominate the global iron ore production, with more than a third of the production. Adding to their market power is the fact that the remaining producers are very small and with limited ability to influence the market. All the aforementioned, coupled with formidable entry-barriers (capital investments required), means that the global iron ore market has all the characteristics of an oligopoly.

It is in this context that a recent radical change to the way that iron ore is priced should be seen. The Economist reports,

"For the last few decades, iron-ore contracts have operated on an annual basis, which gave buyers a degree of pricing certainty. In the last month, however, mining companies – led by the UK's BHP Billiton and Brazil's Vale – have forced steelmakers to switch to quarterly contracts so that they can respond to market conditions better. That makes steel prices harder to predict. As a key end user of steel, the automotive industry is particularly exposed to this price volatility... Mass carmakers are particularly badly affected, because the metal accounts for a higher proportion of their end-prices."

The massive Chinese purchases too have contributed towards the break-up of the traditional benchmark pricing system (where the few large miners and steel makers arrived at a mutually acceptable rate). The Chinese, who made up 45% of the global steel consumption in 2009, have refused to accept the secret deals, and have preferred to make large purchases on the spot market. While this has boosted the spot market and various hybrid pricing contracts, it has also had the unintended effect of increasing price volatility and thereby hurting the auto-makers in particular.

This volatility comes even as the global demand, especially from the emerging economies, shows signs of recovering. The Economist Intelligence Unit has forecast that the price of steel will average US$568 per tonne in 2010, compared to US$489 in 2009 and US$889 in 2008.

This volatility (with an upward bias) makes longer term pricing strategies unremunerative for the producers, who stand to profit from the short term price fluctuations with a flexible pricing strategy. However, end users (like automakers) who found the certainty associated with the benchmark pricing strategy attractive, are now feeling the brunt of the price volatility.

In this context, standard principles of contracting would have it that price risks should be borne by those who are able to bear it at the lowest cost. An extension of this arguement to the price volatility risks facing iron ore producers and end-users would suggest that the later are less well-positioned to bear the risk. This would mean that a more transparent long-term benchmark pricing strategy is the most efficient pricing contract.

Thursday, May 13, 2010

EU and US - divergent policy responses

Here is my op-ed in Mint about the divergent policy responses to the crisis facing the Greek economy. The backgorund material is available in the links here.

Comparing sub-prime bailout with Greek crisis

Historians and economists will surely judge the recent sub-prime meltdown and the Euroland crisis as classic studies in contrast. The contrasting policy responses to these two systemic risk generating events are reflective of a deep ideological divide - intervene swiftly and massively to limit damage or wait and watch while the dynamics of the market plays itself out. This also points to the deep limitations of macroeconomic policy making and the lack of any unanimity among policymakers in effectively responding to such crises.

The EU and IMF may have finally cobbled up a 110 Euro (or $140 bn) joint bailout of Greece, but it is increasingly looking like a "band-aid on a corpse".

Assume Greece is AIG, Portugal is Wells Fargo, Italy is Citibank, Spain is Bank of America, and so on. In fact, bellweather Iceland may be seen as the Lehman of Europe. There are striking similarities between them, as they faced existential crises and generated an explosion of systemic risk. The large leverage that those firms ran up is similar to the unsustainable debt burdens of these European economies. These firms posed the "too-big-to-fail" problem, whereas the economies pose the "too-interconnected-to-fail" (German, French, and British banks own the bulk of Greek debt) challenge.

However while there are striking similarities in the problems facing them, the remedial actions taken by policymakers to address the respective situations could not have been more starkly different.

In response to the "mother of all credit squeezes" that followed the sub-prime meltdown, the US Federal Reserve, and the Bush administration first and then the Obama administration, moved in swiftly to contain the crisis. They hurled every available policy option at the problem ("shock and awe" the financial markets) and the Fed emerged as the lender and insurer of last resort. Even though the bailout programs changed course repeatedly, were characterised by much confusion and lack of clarity, and faced widespread criticism, the central thrust of bailing out the beleaguered financial institutions remained a constant. It is by now widely-acknowledged, that the swift action to bailout financial institutions and its enormity, have been responsible for averting a disastrous, long-drawn out meltdown of the financial markets and ensuring that Wall Street returns to some semblance of normalcy quickly.

In stark contrast, the response to the Euroland crisis has been marked by indecision, a stubborn refusal to confront the reality and the recent example of US bailouts, and a reluctance to commit anything other than the barest minimum of assistance to keep Greece afloat. The ECB has been virtually paralysed, deeply constrained in carrying out any monetary expansions by the rigidities inherent in the Stability Pact and its own ideological reluctance to undertake such operations. In the absence of a powerful enough central executive, the larger Euroland members, led by Germany, have been loath to volunteer with any assistance, in the mistaken belief that it was Greece's problem and any largesse would engender moral hazard.

Unlike the Bush and Obama administrations, the Germans and French governments have shown a remarkable preference to let Greece fail, strongly rationalizing against picking up the tab for Greece's indiscretions. This is all the more surprising given the fact that any Hellenic default, could devastate their own massively over-exposed banks. A recent estimate by the New York Times pointed out that the German, French, and British banks own $704 bn, $910 bn, and $420 bn respectively of Greek, Spanish, Portuguese, Italian and Irish debts (PIIGS). Therefore letting Greece default and force a "haircut" on its bondholders would be tantamount to cutting the branch while sitting on it.

Adding to the interconnectedness tangle is the fact that the banks from PIIGS themselves own large amounts of debts in each other. And dramatically amplifying the problem and giving it a global dimension is the fact that United States banks have $3.6 trillion in exposure to European banks, according to the Bank for International Settlements. That includes more than a trillion dollars in loans to France and Germany, and nearly $200 billion to Spain.

If worries about the safety of European banks intensify, it could push up their borrowing costs and push down the value of more than $500 billion in short-term debt held by American money-market funds. Uncertainty about the stability of assets in money market funds signaled a tipping point that accelerated the downward spiral of the credit crisis in 2008, and ultimately prompted banks to briefly halt lending to one other.

The Times has an excellent article that sums up the challenge facing the EU about the need to speed decision-making before irreversible damage is done and the euro itself slips into history,

"The delays are inevitable, most experts say, stemming from the nature of the European Union and its own institutional voids: no single government, no single treasury, no effective fiscal coordination, no mechanism for crisis management.

Every major decision on the euro must be negotiated among member states and European institutions, a torturous process that also plays up political fissures both within and among member countries. That breeds uncertainty and even panic among investors, who already doubt that the Greek deal that the European leaders finally sealed on Friday night will forestall an eventual restructuring of Athens’ crippling debt."

In the deeply interconnected global financial market, where market confidence can erode with spectacular speed, and contagion effects can be amplified dramatically, a "wait and watch" game can be fatal. In fact, it is now certain that the costs, to everyone including the Germans, of the inevitable default-cum-bailout of Greece will be many times more than what would have been required if a large enough debt restructuring bailout was executed at the first signs of the crisis. In many respects, given the strong moral hazard effect on other beleaguered peripheral economies, Europe will be facing the worst of all worlds now with its late bailout of Greece.

Both these events are testimony to the fact that the cascading effect of crashing market confidence can be far more damaging than the moral hazard concerns and dangers of "socializing private losses" generated by any swift tax-payer sponsored bailout. Once the crisis breaks out, a delayed response will only exacerbate the problems and leave policymakers to traverse a path which is both longer and more inclined, before some semblance of normalcy can be restored.

As economists like Paul Krugman have argued by pointing to the wage and price increases of these economies with resultant erosion of external competitiveness, the origins of the Euroland crisis goes much beyond the large national debt burdens. The Stability Pact, governing the rules of macroeconomic management of Euro members, and the single currency, have meant that the individual members do not have access to any of the conventional monetary and exchange rate tools - like lowering rates, stoking inflation, or even devaluation - to address such crises.

The Euro Project therefore highlights the ineffectiveness of economic union without much greater political integration. They underline the importance of a strong central co-ordinating power and fiscal authority within the EU, apart from a more powerful European Central Bank, with greter willingness to effectively manage such crisis. Some have suggested setting up of a European Monetary Fund to combat debt and balance of payments crisis among EMU members.

Wednesday, May 12, 2010

The European effort to "shock and awe"

So after all the reluctance and prevarication, and faced with inevitable sovereign defaults and the very real possibility of a global contagion (with a resultant double-dip global recession), the Europeans have finally acted. Taking a leaf out of the Obama administration's $700 bn bail out of Wall Street, the EU and IMF announced a $957 bn rescue package of Greece, Portugal and Spain, to "shock and awe" the financial markets so as to revive confidence in Euroland.

This new package follows the failure of the $140 bn EU-IMF bailout last week to enthuse the markets. In contrast, the latest, completely unexpected announcement, has brought cheer to the markets. Equity markets across the world surged in response to the rescue package.

The EU finance ministers agreed to provide $560 billion in new loans and $76 billion under an existing lending program, while the IMF agreed to give up to $321 billion separately. The package also includes the creation of a "special purpose vehicle" to disburse the 440 billion euros in new loans, should that support be required by member states in economic difficulties.

Further, the European Central Bank (again reflecting what the Fed did in the US) announced that it would intervene in the government and corporate bond markets to provide liquidity and prevent freezing of credit markets. The ECB, which has so far rebuffed calls to inject liquidity into the markets by buying back European bonds, announced that it would take whatever steps were necessary to smooth out the secondary markets for public and private debt.

And in a sign of the spreading anxiety about the crisis spilling over outside Europe, the Fed, along with the ECB and the central banks of Canada, Britain and Switzerland, announced the establishment of swap lines intended to make it easier for European companies, institutions and governments to borrow dollars when they need them. Under these swap lines, the Fed will be printing dollars and exchanging them for euros to provide more liquidity, and thereby help the ECB make dollar-denominated loans to European financial institutions.

The swaps are broadly similar to one that the Fed itself introduced in December 2007 following the sub-prime meltdown. Under that, the Fed provided dollars to central banks in exchange for an equivalent amount in foreign currency (the foreign central banks paid the Fed interest equivalent to what they made from lending the dollars; while the Fed did not pay any interest on the foreign currencies it took in exchange, having agreed to hold them instead of lending them out or investing them in the private markets), based on prevailing exchange rates, and the parties agreed to make the same exchange in reverse at a later date — anywhere from one day to three months later — using the same exchange rate as in the initial transaction.

Though the completely unexpected nature of the rescue announcement has "shocked and awed" the financial markets, whether it is adequate or not is another matter. While it may be a step in the right direction and around the requirement to restructure the debt liabilities of these countries (atleast for the time being), they will do little to avoid the inevitable fiscal austerity that these countries will have to undergo. I have blogged about this in an earlier post here.

Paul Krugman argues that while the bailout plan appears to confuse a solvency problem for a liquidity problem, the ECB's willingness to undertake expansionary policies is a welcome sign. The possibility of inflation in Eurozone due to an expansionary policy by ECB could reduce the extent of deflation required by the likes of Greece to regain their competitiveness.

Some have criticized the bailout for containing only new loans (to help Greece and Co raise money at normal rates so as to reschedule its debts) instead of any actual decrease in the debt burden. They claim that this will only delay the ineveitable default by helping these countries raise enough money to temporarily repay their debts coming due in the immediate future. Further, as Krugman pointed out, it overlooks the fact that some of the debtors may actually be insolvent and may not be able to repay them at any time.

While this arguement is surely correct, like the US bailout, the broad underlying premiss of such liquidity support bailouts is that by making available ample liquidity at lower than prevailing market rates, the beleaguered firms and countries may be able to buy enough time to repair their balance sheets and for normal economic activity to get restarted. In other words, hope that with time market confidence returns and everything will be back to normal.

I am inclined to the opinion that this line of arguement overlooks the fact that Greece (and others) would need more than just reschedule its debts to return to normalcy. I have already blogged about the more fundamental structural challenges facing these countries. The resuce package will sure help, indeed it is a small first step in the long road to recovery. In fact, as Simon Johnson and Peter Boone have shown, even with a rescheduling of debts, the numbers are so staggeringly dismal and even the medium-term economic prospects too bleak that nothing short of a default (with haircuts) will help Greece. And even with all this, fiscal austerity cannot be avoided.

Even accepting the importance of reassuring the banking system of European commitment to maintaining financial market stability, the creditors to these nations surely deserve to be penalized for their irresponsible lending decisions. The massive exposure to Greek, Italian, and Spanish debts by German, French and British banks cannot be justified based on any fundamentals-based evaluations. It is clear that they lowered their guards and indulged in irresponsible lending to governments and private agencies in the peripheral economies.

The present structure of the rescue packages, which effectively seeks to provide the ailing economies with more money to enable them to reschedule/roll-over their existing debts, is more beneficial to the creditor banks than the debtor nations. Their debt burden will remain unchanged, while the banks get away without any loss.

A more equitable approaach would have been to tailor a debt restructuring program, on the lines of the Argetine default of 2001, wherein the creditors take a "haircut". Another approach would have been to atleast impose a moratorium on interest payments and roll-over the loans for longer-tenors at the same rates. In both cases, the bankers would be held accountable for their lending decisions.

By setting up a special purpose vehicle to raise loans (not clear whether the loans would be raised with the sovereign backing of European governments, including German and French governments or at prevailing market rates and then given at subsidized rates to Greece and Co) and the lend to the the affected nations, the creditors are effeectively incentivized to exit with their principals, and leave the SPV to fill in the credit gap. If this trend plays itself out for all the peripheral nations, then $ 1 trillion could disappear very fast.

Update 1 (13/5/2010)

Economix has questions and answers with Simon Johnson, Yves Smith, and Carmen Reinhart here, here and here.

Update 2 (14/5/2010)
A summary of Vox economists on the Euro crisis.