The European Court of Auditors has released this account:

​The European Commission was not prepared for the first requests for financial assistance during the 2008 financial crisis because warning signs had passed unnoticed, according to a new report from the European Court of Auditors. The auditors found that the Commission did succeed in managing assistance programmes which brought about reform, despite its lack of experience, and they point to a number of positive outcomes. But they also identify several areas of concern relating to the Commission’s “generally weak” handling of the crisis: countries treated differently, limited quality control, weak monitoring of implementation and shortcomings in documentation.

Among the more specific complaints this is interesting:

Different approaches: the auditors found several examples of countries not being treated in the same way in a comparable situation. In some programmes, the conditions for assistance were less stringent, which made compliance easier. The structural reforms required were not always in proportion to the problems faced, or they pursued widely different paths. Some countries’ deficit targets were relaxed more than the economic situation would appear to justify.

So this is basically saying that politics interferes with the economic policy, with some countries getting better deals (or are able to renegotiate – think Ireland) while other countries get worse deals (think Greece, especially the Tsipras government). There is much more to be criticised, like the fact that the Eurogroup is an informal institution now ruling over large parts of Europe. From an auditing perspective, accountability should be a concern.

Mario Draghi had an interesting ending in his ECB press statement on last Friday (not my highlighting):

In particular, actions to improve the business environment, including the provision of an adequate public infrastructure, are vital to increase productive investment, boost job creation and raise productivity. The swift and effective implementation of structural reforms, in an environment of accommodative monetary policy, will not only lead to higher sustainable economic growth in the euro area but will also raise expectations of permanently higher incomes and accelerate the beneficial effects of reforms, thereby making the euro area more resilient to global shocks. Fiscal policies should support the economic recovery, while remaining in compliance with the fiscal rules of the European Union. Full and consistent implementation of the Stability and Growth Pact is crucial to maintain confidence in the fiscal framework. At the same time, all countries should strive for a more growth-friendly composition of fiscal policies.

I guess that this is as far as a central bank president, who has no power over fiscal policy, can go. The German press, if I am not mistaken, have ignored the plea for expansionary fiscal policy. At least the article in SPON did not mention it and I do not recall any other newspaper mentioning it last week. This is why I chose the title:

Draghi: “Fiscal policies should support the economic recovery”

This is news in Germany.

Posted by: Dirk | January 5, 2016

Some random thoughts on inequality

I am reading some articles on inequality to see where the debate is today. Let’s start with last year’s review of Piketty’s Capital in the 21st century by Bill Gates, the founder of Microsoft:

I very much agree with Piketty that:

  • High levels of inequality are a problem—messing up economic incentives, tilting democracies in favor of powerful interests, and undercutting the ideal that all people are created equal.

  • Capitalism does not self-correct toward greater equality—that is, excess wealth concentration can have a snowball effect if left unchecked.

  • Governments can play a constructive role in offsetting the snowballing tendencies if and when they choose to do so.

My feeling is that most economists – those that are on the scientific side, and not on the ideologically bound side  – would agree with Piketty (and Gates) as well. Economic textbooks of the neoclassical kind tell us that wage equals marginal product of labour. That, however, is fiercely disputed by many economists. There is an article on Crooked Timber that makes this point under the title of It’s bargaining power all the way down:

But when we realize that changes in the value of existing assets are central not just to the decline in wealth ratios in the mid-20th century, but to their whole evolution – including their rise in recent decades – then the mid-20th century decline no longer looks like a special case. It’s bargaining power, it’s politics, all the way down. The same kind of redistributive projects – the decommodification of basic services like healthcare, pensions, and education; the increased bargaining power of workers within the firm – that were responsible for the fall in the capital share in the mid 20th century were responsible, in reverse, for its rise since 1980. In which case we can learn as much about our possible futures from the 20th century decline in the claims of property over humanity, as from their recent reassertion.

This ties in nicely with my political economy course from last semester. Economics and politics are intertwined, and most of the times economic reasoning was motivated by particular interests that would gain from a change in policy. It was probably more obvious when nations sponsored state universities in the 19th century, but today the outcome might be the same. Political power interferes with the way professors are hired, and there is a serious distortion in economics.
If inequality is a problem, and I agree with Gates and Piketty, then we need a different kind of economics to attack it. The discipline seems to agree, as the NYT reports from the American Economists Association meeting:

The economic association’s meeting is something of a barometer of what concerns economists most, drawing more than 13,000 attendees from the ranks of academia, as well as research groups and the private sector. And in panels, research presentations and speeches, what was once mainly a preoccupation of ivory tower Marxists and other players on the margins of the profession is taking center stage.

This reminds me of the famous quote: “If we want things to stay as they are, things will have to change.” For good or for bad, things will change and whether they will stay as they are we will see. However, not changing is not an option. Welcome to 2016!

Posted by: Dirk | December 30, 2015

Finland’s economy in 2016

The picture for Finland’s economy in 2016 is bleak, according to Bloomberg:

Without the option of currency devaluation, the government has calculated that Finland needs to lower its labor costs as much as 15 percent to catch up with its main trade partners, Sweden and Germany. Finland’s economy has shrunk for the past three years and Nordea, the biggest Nordic bank, predicts further contraction in 2015. Finland will be the weakest EU economy by 2017, when it will grow at less than half the pace of Greece, according to the European Commission.

There is a problem with shrinking wages, which is the subsequent fall in aggregate demand. Quite obviously, if people have less income they will buy less goods and services. This is too bad, because the expenditure of one person is the income of another. Wage cuts did not “work” in Spain and did not “work” in Greece or anywhere else in the euro zone. If they are now applied to Finland then one wonders why countries engage in policy experiments that are very likely to turn out disastrous.

The foreign minister of The Finns Party has apparently said that it was a mistake for Finland to join the euro (see article above). Support for the common currency quickly approaches zero, it seems. The euro-peans are stuck with a currency that nobody likes and quickly has become the scapegoat for all kinds of economic problems, often correctly. In Spain, another government of the austerity kind was rejected by the electorate. It is political suicide for national governments to follow the eurozone rules.

As the saying goes: if something cannot last forever it will stop (Herb Stein).

Posted by: Dirk | December 28, 2015

The failure of HBOS is a failure of textbook economics

The Bank of England’s report on the failure of HBOS has been published last month. It is quite revealing:

The FCA/PRA Report documents particular, and dominating, cases of inappropriate risk taking, in the management of credit risk in the Corporate Division, the expansion overseas without regard to the risks involved, and funding the assets of the bank. The strategy of HBOS put the growth of the bank above these considerations until it was too late and impossible to change course. The last point here is important. The management of a firm is not required to have perfect foresight. The criticism in the Report is not that management failed to predict that there would be a global financial crisis. Rather, they should have put in place strategies that could in combination accommodate and respond to, in a timely way, changes in external circumstances. With these strategies firms can for example raise new capital or adjust their funding with the necessary confidence of success. HBOS lacked these strategies.

This goes against the usual microeconomics where it is assumed that firms maximize profits. The textbooks need to be rewritten. While HBOS is an outlier, nevertheless it is too-important-to-ignore. It is when things go wrong that we need economists to explain what happened. Commenting the failure of HBOS by saying that on average firm profits are zero and that profit maximization always maximizes welfare is just plain wrong.

Posted by: Dirk | December 24, 2015

Required reserves are an implicit tax on banks, says Fed

I have often talked to people who think that required reserves “work”. They believe that an increase in the ratio of required reserves (to deposits) will stop borrowing – or rather lending. That is not what seems to be happening, as lots of available evidence shows. Among others, there is a paper by Finn Körner and myself on Chinese monetary policy. We find that even though the required reserve ratio is varied over time, an increase does not mean that the quantity of bank loans stop growing. There is hence no easy way to connect required reserves to the quantity of bank loans. Instead, it is quite well-known that required reserves are a tax on the banking sector, since they used to get no interest for holding these reserves in a special account at the Fed. The US central bank now does pay an interest rate on required reserves. The Fed also writes on its website:

The interest rate on required reserves (IORR rate) is determined by the Board and is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions.

So, both theoretically and empirically there are sound arguments against using the required reserve ratio as a tool to influence the quantity of credit. Nevertheless, you can still use it as a tool to drain excess reserves and put a floor to your short-term interest rate. After all, nobody in the money market will be willing to lend at a rate below the deposit rate that is paid on both required and excess reserves.

Posted by: Dirk | December 24, 2015

Fed uses Reverse Repurchase Agreement Operations

This is from the NY Feds FAQ:

Participation in the operations is open to the Federal Reserve’s primary dealers as well as its expanded RRP counterparties. Expanded RRP counterparties include a wide range of entities, including 2a-7 money market funds, banks, and government-sponsored enterprises. Additional details on the RRP counterparties are available on the New York Fed’s website.

The Fed is active in the money market, engaging with clients like money market funds, banks and GSEs. The target is to move the interest rate up to the new range of 1/4 to 1/2 percent:

The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

This excerpt is from the Press Release of last week. Obviously, to get the short-term interest rate in the money market up, the many, many reserves that have been put into have to be drained. This is what the reverse repo business is all about: take reserves out of the market and put into their place interest earning assets. These will be treasury securities, repoed in a way that the interest rate matches the target. For instance, if a $100 treasury security yields 1% nominally but the target range is .5%, then the security is sold at $100.5 and bought back at $101. Since this is done overnight we have talk about fractions.

Here is a picture from FRED about the severity of the task the Fed faces:

res_bal

As the Fed has explained: “the Desk anticipates that around $2 trillion of Treasury securities will be available for ON RRP operations to fulfill the FOMC’s domestic policy directive.” Given that there are also required reserves and other reasons not to go to zero, this is roughly a good fit. The Fed should have enough firepower to get where it wants to go. If not, they can always engineer more interest earning assets. Either this would be done through clever financial engineering, or by brute force: central bank bonds. Both are available without limit, so if the Fed wants to hit a target rate it can!

Posted by: Dirk | December 23, 2015

Money and sovereignty in the US: the case of Puerto Rico

The NYT reports on the financial situation in Puerto Rico, a Caribbean island that is a US unincorporated territory:

On the surface, it is a battle over whether Puerto Rico should be granted bankruptcy protections, putting at risk tens of billions of dollars from investors around the country. But it is also testing the power of an ascendant class of ultrarich Americans to steer the fate of a territory that is home to more than three million fellow citizens.

This is quite interesting because Puerto Rico is like Greece in Europe: it has debts in foreign currency but the central bank would not buy its liabilities in a way that ensures that solvency is not an issue. The US territories that are US states also could face bankruptcy, so this is not about Puerto Rico being a special case. The article continues:

To block proposals that would put their investments at risk, a coalition of hedge funds and financial firms has hired dozens of lobbyists, forged alliances with Tea Partyactivists and recruited so-called AstroTurf groups on the island to make their case. This approach — aggressive legal maneuvering, lobbying and the deployment of prodigious wealth — has proved successful overseas, in countries like Argentina and Greece, yielding billions in profit amid economic collapse.

 

There it is. Bankruptcy for profit, just as in the NBER paper by George Akerlof in 1994:

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

The world is an odd place, but this is one of the strangest plays in the capitalist playbook! For those interested in the topic, here is a link to Bill Black’s testimony before the Oireachtas’ Joint Committee of Inquiry into the Banking Crisis.

Posted by: Dirk | December 23, 2015

Bank of Japan engages in industrial policy

The Neue Zürcher Zeitung (NZZ, from Switzerland, German-speaking) reports:

Gezielt will sie Firmen fördern, die in Maschinen oder Mitarbeiter investieren. Das ist reine Industriepolitik. Die Bank unterstützt damit die Regierung, die will, dass die Unternehmen mehr für die Erholung der japanischen Wirtschaft tun. Damit beweist die japanische Notenbank aber einmal mehr, dass es um ihre Unabhängigkeit schlecht bestellt ist.

So, the Bank of Japan  – the country’s central bank – will promote firms that invest in machines or human capital. This, according to the NZZ, is pure industrial policy. The bank would support government, which wants companies to do more for the recovery of the Japanese economy. Once more the central bank would prove that it is not properly independent.

Personally I would prefer the Japanese government to cut taxes and increase spending, which is the more conventional choice to stimulate your economy. However, I don’t know much about Japanese politics – the idea to raise taxes in the beginning of a recovery struck me as ideologically motivated – so maybe this is a viable second best solution to a lack of demand?

Central bank independence can be positive, but if the result is that a central bank declines to support the government’s policies to increase economic growth then there must be a trade-off. Industrial policy by a central bank is not a first. Actually, the Bank of Japan has engaged in something called window guidance in the second half of the 20th century (source):

Throughout the postwar period of rapid economic growth in Japan, the Bank of Japan (BOJ) has guided lending by financial institutions. This “window guidance,” as it is called, sometimes takes the form of restrictions on lending by major financial institutions, particularly during periods of tight monetary policy (Suzuki 1987).

Given that many countries in the periphery have lost some of their industrial base, the Japanese post-war experience and the trouble with bubbles might hold a lesson or two for these countries?

The Report on systemic risks in the EU insurance sector has been published last week (download). Here is an excerpt:

Given this role in the economy and the financial sector, the ESRB Insurance Expert Group (IEG)1 has identified four main ways in which insurers can be the source of systemic risks or amplify these.

First, in line with literature to date, insurers may amplify shocks due to their involvement in so-called non-traditional and non-insurance activities. [..]

Second, procyclicality can arise. [..]

Third, life insurers in parts of Europe could create disruption by failing collectively under a scenario with prolonged low risk-free rates and suddenly falling asset prices (i.e. “the double hit”). [..]

Fourth, underpricing by an insurer, if left unnoticed in microprudential supervision, could lead to a lack of substitutes in certain classes of insurance vital to economic activity. [..]

I would propose a fifth entry:

Fifth, under-/mispricing by an insurer, if left unnoticed in microprudential supervision, could lead to a credit bubble in certain classes.

Remember American Insurance Group AIG)? They insured clients against credit-debt default of underlying mortgages and real estate loans, assuming that the housing market in the US would not fall apart at the same time because historically it didn’t. Even though the bail-out according to Wikipedia led to a profit for the US government, the misallocation of capital did hurt the US economy. Instead of real estate something else could have been build, and the return in terms of welfare improvement would probably have been better.

Reading the report more thoroughly I find that the first point covers cases like AIG:

First, in line with literature to date, insurers may amplify shocks due to their involvement in so-called non-traditional and non-insurance activities. These activities imply liquidity and maturity transformation, leverage, complexity and interconnectedness and include variable annuities, certain types of guarantees and speculative derivative transactions. A prime example for such risks is AIG in the financial crisis. A rough estimate of the amount of non-traditional insurance products in the EU is at least EUR 125 billion. Due to insufficient reporting the number is probably understated; the quality of reporting will improve under Solvency II.

Nevertheless I find the description “insurers may amplify shocks due to their involvement in so-called non-traditional and non-insurance activities” a bit too nice. Insurers may cause shocks if they engage in practices that are not scientifically sound. This can lead to very high profits in the short-run but huge damage in the long-run. I am quite sure that ESRB is aware of that. Speaking of which: The Big Short is out now. Sadly, it does not tell you what really happened but instead blames stupid people for buying financial assets that they did not understand. Anyway, here is the trailer. I hope that people who see the movie afterwards want to know more about what happened. Naked Capitalism has a good blog post on that.

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