Friday Roundup

Some more bond vigilante-unsustainable debt commentary for the UK. The analysis is peculiar because the question is why so many people are willing to invest in UK bonds now. If expectations for the future are dour, why would investors have faith now? This may be linked to the story on a possible bubble in US government bonds. Current demand for safe assets is because of collateral needs; once the economy recovers borrowing costs are going to skyrocket.

Koo takes a close look at Eurozone fiscal and monetary union dynamics, and concludes that neither system deals with balance sheet recessions effectively, especially as they are often asymmetric shocks. An interesting point is that monetary policy, when it tries to ease the impact of these shocks for certain states (ie Germany), the cheap credit causes new problems in other countries. For as much as the ECB pursues "Deutschland über alles", there may be nothing left to be over if the monetary union doesn't develop a system of interstate transfers.

Demand for safe assets doesn't necessarily lead to a shortfall in aggregate demand...only if monetary policy can function as an offset. Is the German current account surplus sucking up your country's growth? Not if your central bank holds tight to a nominal aggregate and keeps growth on track. Just as Scott Sumner says, if your central bank is doing a good job, there are no "depression economics"; fiscal policy doesn't boost output, and current account deficits don't hurt growth. The article does outline a pretty scary chain of events for why demand shocks matter

If demand still fails to materialise, economies go on to restructure via the supply-side.
A vicious circle ensues as capacity is reduced at the expense of the least efficient businesses. Unemployment rises. The economy contracts.
All the while those who still have wealth are encouraged to hoard even more, a fact which only exentuates the contraction in broad money supply, preventing liquidity from reaching those who would most likely be prepared to spend.

Is there really that much regulation holding back the natural gas energy boom? It doesn't look like it. If anything, regulation looks to be too lax, with large scale environmental concerns just shoved under the rug. The NYT piece does bring up an interesting point. Companies, at this point, have an incentive to just get the gas out as fast as possible, before the regulations start coming into effect. Sounds like a dangerous starting point with massive first mover advantages.

Greater transparency in European repo markets would be helpful, but to what extent would it actually solve anything? No doubt more aggregate statistics would help with systemic regulation, but there's still concern that unknown unknowns could crop up. Especially since there's no legal way to force every piece of data from firms, there could always be off-sheet risks building up. And when individual transactions can lose billions of dollars, these unknown risks could break the bank.

Also on the transparency front, European governments are resisting shifts to more transparent accounting standards. It looks like many European states, especially Germany, are concerned about hidden pension debts that may rise to the surface. This does not bode well for the Eurozone in the medium-term, even if national leaders can't wade through the politics to an agreeable solution.

On the topic of the Eurozone, there's an interesting new VoxEU article on the tragedy of the commons problem with regard to the ECB and the peripheral central banks. In a nutshell, the authors argue that since national banks could determine what collateral was considered "safe", they would have an incentive to be too lenient on their own banks in order to gain an advantage in lending costs in the Eurozone. In effect, each national bank's action had a negative risk externality that would be born by the entire Eurozone. This means that fiscal solutions to the crisis are not sufficient. The problem goes deeper, starting with the conflicting incentives of sovereign central banks and the European central bank.

Friday Roundup

Niall Ferguson takes a break from his usual Newsweek hackery and takes a look at the political constraints surrounding the Eurozone. The narrative is rather similar to previous ones regarding the decentralization of economic and political power, and all the attendant problems that arise with coordination. Killer paragraph from the article:

Imagine that the United States had never ratified the Constitution and was still working with the 1781 Articles of Confederation. Imagine a tiny federal government with almost no revenue. Only the states get to tax and borrow. Now imagine that Nevada has a debt in excess of 150 percent of the state’s gross domestic product. Imagine, too, the beginning of a massive bank run in California. And imagine that unemployment in these states is above 20 percent, with youth unemployment twice as high. Picture riots in Las Vegas and a general strike in Los Angeles.

Now imagine that the only way to deal with these problems is for Nevada and California to go cap in hand to Virginia or Texas—where unemployment today really is half what it is in Nevada. Imagine negotiations between the governors of all 50 states about the terms and conditions of the bailout. Imagine the International Monetary Fund arriving in Sacramento to negotiate an austerity program.

Capital control regimes look to be an interesting field of analysis for the future. The authors do make an important note: control over the capital account, to a certain extent, implies a control over the balance of trade. this is an important point for future negotiations, as it is a reason why capital controls should be used sparingly.

Apparently Bernanke doesn't shy away from strong language when the financial system is on the line. Although he's been relatively lukewarm about further easing to lower unemployment, he seems totally on board to do "whatever necessary" to stop the Eurozone contagion from spreading to the United States. One wonders what's the consideration preventing him from doing something similar to solve the US employment crisis.

The political argument about Glass-Steagall is quite interesting. The thesis goes that, after the merging of commercial and investing institutions, bank lobbies became much more unified, thereby warping the government towards helping the banks. This seems like an issue that would be interesting to study in a political business cycle or political DSGE model. It would make banking regulation endogenous, and the results could be quite unpredictable.

While I do think the broad enets of the efficient market hypothesis are true, I think the new concern with systemic risk is well deserved. I think viewing the EMH as a limitation on information, and not a limitation on the presence of crises is very important. Otherwise it leads to a dangerous bias, as described in the article:

There may be a deeper bias at work. In business and investing, choices under conditions of uncertainty are made all the time, and mistakes are routine. By contrast, developed country policymakers’ default stance seems to be that proactive or preemptive measures require a high degree of certainty, owing to a deep-seated belief that financial markets are stable and self-regulating. 

If one believes that market instability is rare, then it is reasonable to refuse to act unless there is a compelling case to do so. In light of experience, the view that the financial system is only exceptionally unstable or on an unsustainable path seems at least questionable.  

Unsurprisingly, the article is short on specifics on how to regulate systemic risk, but it is certainly one of the biggest issues for financial stability.

Finance is incredibly complicated, making it hard for anyone to regulate it. This is one of the issues that makes me skeptical of the argument that markets can regulate themselves when it comes to complex financial products. The payoffs are too volatile and uncertain for the market to truly know. Of course, it's unlikely that regulators know any better. However, this is no excuse for government to throw up its hands; rather, it's an opportunity to craft simpler rules that are robust to errors.

What are the systemic risks associated with money market funds? They played a large role in the liquidity crisis and financial turmoil in 2008, and thus their systemic role will be important for future analysis.

An insightful look into the failure of the Gaussian model and the real reasons why it was so destructive. Modelers never truly believed in it, and rating agencies never got around to implementing them. However, due to the demand for AAA rated assets, financial engineers gamed the system to satisfy the demand and earn hefty bonuses. It seems that the story is much more about individual incentives and corporate governance, and much less about an "equation that destroyed finance" or the financial conspiracy.

Friday Roundup

China is not much of a global economic leader. China doesn't see financially protecting Europe as critical for its own economy; it feels that is is segmented enough to protect itself. This also shows how China is not willing to provide global public goods (ie stable finance). It is no economic hegemon, and therefore doesn't act in a way conducive to global economic coordination.

There's been a series of good posts from FT alphaville on the issues facing European finance. Given the meteoric rise and fall of finance in Europe, one has to wonder why the markets didn't price in the risk. The most plausible answer? There was too much that they could never have known; markets were too opaque. This should be a lesson for people who think they can "calculate" the optimal level of risk. You know too little about probabilities to make a surefire judgment; you should resort to looking at fragilities instead.

Banking union? Not likely. International economic coordination is hard, and Europe isn't quite up to it. There's just too many different interests at play for a banking union to work; who would we hold responsible to pay? Banking is a market that extends beyond governance, which makes it almost impossible to solve the problems with capital flight and get the Euro on solid footing.

China is slowing down further: steel edition It's really quite staggering how many different factors are converging at the same time: China bleeding into Australia, India slowing down, and then the Eurozone is falling apart. We have no idea how bad it's going to get, which makes the fragility of all financial systems particularly worrisome.

Global equities fall on the announcements of one Federal reserve chair. Asia was counting on further easing, and the fact that Bernanke didn't come out clearly in support of it is not good news. The announcement really marks how the United States truly is a monetary superpower; a tentative decision on QEIII is enough to send markets roiling. These are the kinds of problems that make me really wish that monetary policy was done in a more rule-based fashion that took into account the gigantic output gap. Perhaps something like NGDP targeting...

More on the safe assets story and the fiscal cliff. This shadow banking dimension is something I want to investigate going forward because it seems to be a new channel for traditional fiscal and monetary policies. Shadow banking seems to make fiscal policy more powerful as it improves the stock of collateral, whereas it makes monetary policy more problematic as stocks of collateral are bought up.

An interesting look at the linkages between Europe and the United States. I think the finance data coupling indicates that the relationship really goes beyond simple export statistics. This is an interesting problem from the concepts of "opacity", because we really don't know the extent of the connection. All that we know is that there are hints of financial coupling, which might make the Eurozone contagion problematic for the United States.

Friday Links and Thoughts

While volatility might be good for antifragility, the presence of volatility hardly means systems are any more advanced. An old trade paper looks at how complexity can be a source of comparative advantage between nations. Because of better institutions in more developed countries, they are able to produce goods of higher complexity at a comparative advantage.  This then explains why less developed countries tend to produce "commodities" that have higher international volatility.

Another trade paper on financial flows and crises.  The abstract is pretty interesting stuff:

In recent years a number of emerging markets experienced rapid expansions in domestic credit. Though …nancial deepening is greatly beneficial to economic growth, it is feared that credit booms increase the likelihood of banking crises. This paper establishes that credit booms are indeed associated with episodes of banking system distress, and that the e¤ect is highly nonlinear in both credit growth itself and the in the impact of other variables during credit booms. We find that larger and more prolonged booms and those coinciding with higher in‡ation and, to a lesser extent, low economic growth are more likely to end in crisis. By contrast, external factors such as real exchange overvaluation or the current account do not seem to consistently affect the crisis probability. Better banking supervision and greater trade openess seem to reduce the crisis probability. 

What I find interesting is that it states exchange rate overvaluation shouldn't affect the probability of a crisis. However, with the Greek situation, I wonder if exchange rate overvaluation would have any effect on the magnitude of the crisis.  Given that overvaluation makes equilibriating trade more difficult, it should theoretically have an effect.

Why can't we just let the power of comparative advantage do its work in solar panel markets?  Of all the things we could be throwing tariffs onto, why solar panels?  Do they produce some externality in another country that we need to be accounting for?  Are we taxing our domestic firms in some way that the tariff would need to balance?  It seems like the primary effect of the tariff would to be slow down the integration of solar panels into the United States.  Maybe instead of protecting our solar panel industry we could start to work harder on a smart grid or other higher value-added products.

More work on globalization's second rebundling as applied to foreign direct investment.  I think it's interesting to think of trade as a combination of locally sourced products and locally consumed products.  The mixes between these two regimes then creates the overall trends of trade, with the wheel-spoke systems characteristic of the second rebundling.

European financial markets are freezing up.  Repo curves are getting inverted; investor uncertainty is shooting through the roof.

Yay, capital injections for Bankia!  While capital injection is the right move, the fact that it's needed is terrifying.  However, spreads on Spanish debt is shooting up through the roof; if Portugal's story was any guide, this does not bode well for the Spanish economy. Eurozone contagion might just spread even if Greece stays with the Euro.

China, why more stimulus? China is pouring more money into large investment projects even though the current investments have a severely negative rate of return. 70 more airports? Even more housing? More railroads? China may not necessarily be overinvested, but the rate at which they're trying to "rebalance" to higher consumption is going in the wrong direction. Pouring good money after bad is not a long term solution to the crisis. The only hope is that the stimulus can tide us over until regional imbalances can be addressed. However, with the increasingly higher levels of credit from the central government, the fragility and the large negative consequences it can engender is terrifying.

Friday Links and Thoughts

An interesting analysis of global supply chains and the recent crisis.  In the Great Recession, European firms that were exporters suffered higher losses of sales than those who were importers or were not very open to international markets.  In terms of a "debundling" of globalization, this means the firms that were the core supply chain coordinators did better in the recession than the export parts periphery.  This suggests that the debundling of globalization makes these supply chain members similar to the commodity exporting countries under previous regimes, as the parts manufacturers are now the commodified, low skill level exporters.

Germany is just stuck in the worst of worlds.  If Greece leaves the Euro early, the chaos of capital flows are likely to overwhelm Europe and cause a more severe economic contraction.  However, if Greece's exit is inevitable, then it may be better to do so now because the costs of an exit are only going to increase in the future.

A new paper on the history of global reserve currencies.  Eichengreen and Mehl find that the US dollar overtook the UK's pound sterling much earlier than previously believed.  The change in dominance took place in the 1920's and the US dollar continued its strength through the end of World War II.  One of the key findings of the paper is that the US dollar was so successful because of the depth of the U.S. financial markets. In effect, because of the large home market in the United States, it was seen as more stable reserve currency.  This has three important implications:

1. First is that finance, in many ways, functions as an increasing returns to scale industry in the short run.  As a result of a larger financial industry, a certain country may gain a comparative advantage in finance.  
2. The second is that larger currency unions, if stable, are more likely to be the base of a global reserve currency.  This is interesting in the context of Europe, because those countries, although they are bound together, failed to foster a shift to a European reserve currency because of fundamental internal imbalances.  Reserve currency status then becomes another key determinant in whether a currency union benefits or hurts a region.
3. Third is that macroprudential policy will be increasingly important for the preservation of a reserve currency. Without that level of moderation to promote medium-term sustainability, financial markets aren't stable enough for reserve currencies to remain.

China's financial system is incredibly fragile.  Although, on aggregate, capital is flowing into China, the flows could easily reverse based on the decisions made by a small population of affluent Chinese.  To me, it represents another reason why fears about China should take place in the tail, and not the medium results.  Growth is likely to be in for a bumpy landing, but if not it is likely to collapse.  Hard.

Perhaps manufacturing is special.  Its recovery has been quite strong in the recent recovery, and it may bode well for the furthering of science and engineering in the United States.  The fact that manufacturing firms played such a large role in increasing spending in research and development creates possibilities that manufacturing really is special in an age of otherwise stagnation.

A credible argument against the Sumner critique of monetary policy.  Is there a possibility that central bank independence could be jeopardized by higher levels of unconventional policy action?  In a world of high levels of debt and overly expansionary fiscal policy, Fed tightening would become a lightning rod for criticism.  At that point, the Fed could easily lose its independence as fiscal authorities came under attack.  Thus, the Fed can't be an omnipotent actor because it would create massive possibilities for moral hazard on part of the fiscal authorities.  This seems to be another interesting avenue for fragility in NGDP targeting.  Central bank robustness leads to governmental fragility.

Friday Links and Thoughts

 It blows my mind how large JP Morgan is.

The total notional exposure of all of JP Morgan's trades has been estimated to be $79 trillion. That's "trillion", with a "T", from a company with an equity value of $140 billion, and falling quickly.

This seems to completely go against the Rodrik argument that markets need to be embedded into governance.  To give an idea of scale, global GDP is only around $63 trillion.  Similarly, Spanish banks are dealing with borrowing levels of  €1.15tr, while Spanish GDP is only €1.41tr.  The top 5 banks in the United States have combined assets of $8.5tr, which is over half of U.S. GDP.  How is this sustainable or, more importantly, not fragile?  Natural environments that have endured for millennia never have animals big enough to crash the entire ecosystem.  Why are we allowing our economies to have gigantic banks?

The republicans are roughing up military alternative energy policy again.  Those ruffians.  It looks like allowing the military to do what they want is alright when it involves large amounts of fossil fuels, but becomes something legislation needs to solve when it starts involving biofuels.

More Greek debt/capital flow drama.  Politics is twisting itself into unsolvable knots; capital is slowly hissing out of the country.  It seems peculiar how this could be controlled further.

Puerto Rico's debt is quite fragile, although I don't know if I would call it a "black swan" like this article.  It frustrates me how often "Black Swan" is used to describe low probability, high impact events.  To me, Taleb's formulation of the Black Swan is an epistemological one.  It's an argument that we don't know what happens at low probabilities, and that these low probabilities are the ones that carry the greatest historical significance.  For day to day affairs, I think more often of fragility and tail risk.

All the money is flowing from peripheral Euro countries and flying into Germany and the United  States.  This is interesting, as it reflects grave fears about the ability of the peripheral Euro countries to pay back their debts.  However, what does this say about perceptions of Germany in the event of a Euro breakup?  Considering the astronomical, unknown costs of a Euro breakup, shouldn't the bond yield for Germany be higher?  After all, they are the ones who will have to bear the weight for most of the lost debt.

David Beckworth brings up an interesting link between indebtedness and expectations of nominal income growth.  While it indicates NGDP targeting may help circumvent a balance sheet recession, it also indicates that NGDP targeting results in financial fragility.  This connection is intriguing because artificial stability in one domain (NGDP) creates fragility in another (debt).  This contrasts with Evan Soltas' recent look at how NGDP targeting helps robust business growth.  If the structural signals are not confused for the macroeconomic noise, markets allocate resources better.  In this other domain, stability in NGDP actually creates more dynamism among businesses.  This is an important general problem for the analysis of fragility.  Does fragility in one domain promote the same in others, or does stability in one domain promote antifragility in others?

Capital flows: the umbrella you have to return when it rains.  BRICs are all suffering capital flight; bad news for the stability of finance.

Friday Links and Thoughts

Wonderful little exposition on the intersection between Technology, Economics, and Psychology.  I find Roy's interpretation on the need to change perceptions particularly interesting: it is almost as if perception needs to be a factor of production.  The example he offers is the UK postal service trying to improve delivery rates for first class mail such that 99% of the mail arrives by the next day.  That task was extremely expensive, but the deeper issue was that people thought that only 50-60% of the mail arrives by the next day, even though at that time the rate was already in the high 90's.  The bad perception made the marginal value of the actual product very minimal.  If this is true, it suggests that impressions should play a much larger role in determining value.

Greek wants to turn back the clock on the austerity negotiations.  It's not really surprising considering the original goals were wildly unsustainable.  Austerity doesn't lead to growth, high debt doesn't necessarily retard it.  It's getting particularly worrisome considering the Greek government is resorting to peculiar national forms of monetary expansion.

A new paper on industrial policy.  I think Chris Blattman's argument that industrial policy can be designed intelligently is true, but the real question is whether it's helpful on an international arena.  I don't know too much about industrial policy, but the thing that bothers me about it is if there's a risk of international "race-to-the-bottom" when it comes to gearing an economy to manufacturing.  Does one country's industrial policy crowd out that of others?  Or instead is it just a rebalancing within each country?

Commodities are being used as part of subprime finance deals?  I see this as just another argument for why risk models are incredibly inaccurate.  Considering there's so many transactions unknown to the public, how can the publicly measured parameters be accurate?

Economic data collectors are under attack.  Why?  There's a possibility that the republicans don't want to give the government the ability to measure statistics to execute policy.  Instead of starving the beast, you could just take away its eyeglasses.  The CATO argument that the free market could take over seems peculiar.  Information is a public good considering it can be accessed by anybody, and a free market solution would have very restrictive funding arrangements, limiting the improvement of policy.

Economic justice is good for development!  The statistics are pretty impressive.  The authors estimate that 17 to 20 percent of growth in the period between 1960 and 2008 can be attributed to the growth in the decrease in discrimination for hiring.

Another example in which individual trade policy doesn't always align with global interests: trade barriers and food volatility.  I'm personally very conflicted on this issue as I do believe countries should have the policy space to pursue trade barriers that have broader distributional implications within their countries.  However, which rights should be granted to states if their own policies interfere with the policy space of others?

Europe breakup shouldn't be that big of a deal.  But how do we know this?  You only have to be wrong once on predicting these crises to be really wrong.  Given the possibility of many hidden risks in the Spanish banks that are now just unraveling, there's still plenty of reasons why the Europe analysis is something to worry about.  Given debt is fragile, it's impossible to prove that it won't collapse.  Only one counterexample is needed for the house of cards to fall on itself.

Randomly lose a billion dollars on a single trade.  These are the kinds of things that make me laugh at those who say the non-normality of financial markets is an insufficient reason to reject much of modern risk calculations.  Non-normality is not some random "exception to the rule".  It is the rule, to which stable returns are the exceptions.

Friday Links and Thoughts

Via Noah Smith, solar panels being used for fossil fuel production.  Will this make solar power more or less competitive vis a vis oil?  If it's true that solar panel technology still needs time to mature and that oil technology is already mature, it seems that the positive externalities from investing in solar for oil production may end up making solar more competitive vis a vis oil.

Debt concerns abound.  Ever since the crisis, CDS spreads have been widening among the 50 U.S. states, and the story for European countries?  That should be old news by now.

Via Karl Smith, another spin on the safe assets problem  How do we deepen capital, how do we save money? Without some riskless asset, the result may just be more and more bubbles.

Dutch politics may increasingly turn against the Eurozone.  This stands as a sobering lesson in hasty attempts at economic integration in domains that aren't sustainable.  It would be a shame if the troubles over the Eurozone end up sowing the seeds for the disintegration of other components of the E.U., such as the provisions for migration and agricultural policy.

A response to criticisms of venture capital.  Turns out that venture capital now isn't doing as poorly as the graphs circulated by Noah Smith would suggest.  Rather, performance is pretty close to what it was 3 decades ago.  Yet this still begs the question, are we in a prolonged period of stagnation?  What does it say about venture capital if the returns were not, and are not, that much better than the market.  Perhaps it's just the EMH borne out; we shouldn't expect excess returns anyways.

Variance among the Eurozone countries is quite high, even the Latin American countries are doing better.  Although I don't think that would be a reason to justify a currency union in Latin America: the limited standard deviations may be the cause of divergences as the result of a balancing mechanism between the countries.

Australia's credit bubble will be an interesting test of whether NGDP targeting holds.  The argument has always been that superb monetary policy on Australia's part fueled them through the great recession.  In theory, money should supercede the effects of credit, but we shall see.

A new form of shadow banking in the form of ETF's doing credit mediation.  How was financial regulation supposed to work again?

More on the Take-the-Best Heuristic model.  It turns out a simple rule is pretty good at predicting elections throughout history, especially when out of sample data is used to calibrate the data.  It's competitive with econometric models, which is quite impressive considering the hegemony of multiple regression.  Why isn't this statistical method used more often?

If LTRO is just a weird form of QE, why is the ECB so committed to using such a suboptimal tool?  Why can't the central bank just commit to a generally more expansionary monetary policy?

Credit is diverging from money in the Eurozone.  This seems to reflect my comment that monetary policy needs to look at more than stocks of M1 or M2 because money is defined on a continuum: it's regime dependent.

Austerity isn't the answer: version over 9000.  Debt consolidation isn't going anywhere; it just doesn't fix the relative price problem between the core and the periphery.

Old post from Brad on fiscal policy.  Good insights throughout.

Why is Japan's currency acting out so weird?  The implicit currency peg seems to be not working.

Links and Minor Thoughts

Chinese politics is complicated.  Especially as the Bo Xilai political turmoil gets more complicated, it's probably important to have somewhat of a grasp on what's going on.

What are the effect of cities on the environment, and how do new trends in manufacturing shape this?  With the past reduction in manufacturing, and now the present revival, it's likely that factories can be built in centers to improve environmental efficiency.

Tepid PMI production news from China.  The tail risk is still worrying me because I suspect that neither the actual probability nor the impact are truly calculable.

Could decentralized solar power send shockwaves through developing countries?  Recent innovations in SMS payment have led a revolution in banking; could it transfer to small scale utilities as well?
Decentralized solar, sweet...

If society is to be based on stochastic tinkering, we need patent reform.  Current patent law makes it impossible for small scale inventors to truly defend their creations.

Yves Smith points out another serious risk for banks: interest rate risk.  Especially if we decide to weight monetary policy more towards a NGDP target, there's a serious possibility for higher interest rate volatility which can wreak havoc on these banks with such long maturity bonds.

I remember perusing through Peter Diamond's paper on the Beveridge Curve after he won the Nobel Prize. I never truly grasped the significance of it, so I found Andy Harless' mini-analysis on the Beveridge curve quite interesting.

High multipliers in times of low interest rates: DSGE edition.  No surprise here, although it would likely change if monetary policy would pull more weight.  This, along with several robust pieces of evidence that austerity fails (private debt much?), all are bad news for the Eurozone.

A reminder for humility: how accurate are the national accounts anyways?  Considering precision can't be that high, don't take each decimal point that seriously.