Reinhart and Rogoff (os)

Some weeks have passed since the great debate, whether Reinhart and Rogoff have made some 'stupid' mistakes in their excel calculations concerning a threshold of a sustainable debt level with respect to economic growth.

However, only last weekend, I have found this nice tv summary on the issue:

Policy Rules for Dummies (cps)

Just as a vital sign: Ever wonder what the whole "rules vs. discretion" debate was about? Again, let Goldman Sachs be of service:

#1: Rules are for the obedience of fools, and the guidance of people like us.
— GS Elevator Gossip (@GSElevator) June 13, 2013

Nanex Order Routing Animation (os)

1/2 second of trading activity in Johnson & Johnson (symbol JNJ) on May 2, 2013

This video was featured at Wired Business Conference (watch it now: http://fora.tv/2013/05/07/Nanex_CEO_E...)

The animation tool that created this video was written in "C" using Windows GDI - simple lines, polygons and ellipses. We wrote it to explain to the SEC and CFTC (the regulators) how our markets work. We got the idea after realizing, in face to face meetings with them, they didn't understand market structure or the importance of latency and the consolidated feed. That was several years ago. We still aren't sure if they get it, or are just playing dumb.

The bottom box (SIP) shows the National Best Bid and Offer. Watch how much it changes in the blink of an eye.

Watch High Frequency Traders (HFT) at the millisecond level jam thousands of quotes in the stock of Johnson and Johnson (JNJ) through our financial networks on May 2, 2013. Video shows 1/2 second of time. If any of the connections are not running perfectly, High Frequency Traders can profit from the price discrepancies that result. There is no economic justification for this abusive behavior.

Each box represents one exchange. The SIP (CQS in this case) is the box at 6 o'clock. It shows the National Best Bid/Offer. Watch how much it changes in a fraction of a second. The shapes represent quote changes which are the result of a change to the top of the book at each exchange. The time at the bottom of the screen is Eastern Time HH:MM:SS:mmm (mmm = millisecond). We slow time down so you can see what goes on at the millisecond level. A millisecond (ms) is 1/1000th of a second.

Note how every exchange must process every quote from the others -- for proper trade through price protection. This complex web of technology must run flawlessly every millisecond of the trading day, or arbitrage (HFT profit) opportunities will appear. It is easy for HFTs to cause delays in one or more of the connections between each exchange.

Papers We Read: United States Then, Europe Now (cps)

This week, we read

Sargent, Thomas J. (2012): "Nobel Lecture: United States Then, Europe Now", Journal of Political Economy, 120 (1), 1-40.

In short, it's a historical case study---set in the 18th- and 19th-century to-be-United States of America---wrapped around the intertemporal government budget constraint. Sargent presents some of his core messages right at the beginning. Here are some examples (quotes in italics taken from pp. 3-4):

1. The ability to borrow today depends on expectations about future revenues. Under the United States' first constitution, the federal government incurred very much debt but didn't have the power to tax accordingly. The consequence was that the respective debt titles traded at high discounts (I don't remember any passage explaining how this was even possible for the federal government---could it really have been ignorance of creditors?). This all changed under the second constitution which traded single states' taxing powers for a bail-out by the federal government.
2. Free-rider problems exist for subordinate governemnts vis-à-vis a central government, which amounts to the classic problem of how to make several parties pay for a public good (for example such a "Glorious Cause" as national independence). This problem was closely connected to the low 'bargaining power' of every single state in trade relations with Great Britain: No state could afford to increase tariffs and the like (the main source of tax revenues at the time) because it would have only benefited the neighboring states. In effect, tax competition made paying war debts on a state level almost impossible.
3. Good reputations can be costly to acquire. While the federal bail-out of the American states at the end of the 18th century created a strong reputation for some decades, a different kind of reputation was generated in the mid-19th century: When another federal bailout was discussed, opponents prevailed, exchanging the USAs standing on capital markets (which was now demolished) for a strong reputation of the federal government vis-à-vis state governments (that introduced balanced-budget rules soon after).

There is more in the article: Two additional lessons (It can help to sustain distinct reputations with different parties and Confused monetary-fiscal coordination creates costly uncertainties). Some math, 80% of which seems a little out of place, but I guess it wouldn't be considered a 'real Sargent' if the paper didn't contain at least a few formulae. And finally, some very nice quotes:

• On economic theory (p. 8, italics added): "For the purpose of (...) buyers and sellers, it is enough to have a good-fitting statistical model (...) But for other purposes, a statistical model alone is inadequate. (...) Economic theory goes deeper by analyzing contending economic and political forces that actually produce a statistical regime."
• Directly following, but worth a separate mention: "In economic theory, an agent is a constrained optimization problem. A model consists of a collection of constrained optimization problems. Theories of general equilibrium, games, and macroeconomics acquire power by deploying an equilibrium concept whose role is to organize disparate choice problems by casting them within a coherent environment."
• A joke at the expense of Milton Friedman (footnote 18).
• "Prejucides help because data are limited." (footnote 20)

What it didn't do was go into much (i.e. only some) detail about "Europe now", which is what you'd clearly expect from the title. Just strike that out, enjoy the rest, and possibly have a look at another historical article by Sargent (co-authored by Francois Velde (1995): "Macroeconomic Features of the French Revolution", Journal of Political Economy, 103 (3), 474-518) if you're interested.

burn....burn (os)

Shocking news todays, especially for the the Phd students with gangsta rap ambitions. It seems like the relaxed times, when we were shopping with our girlfriends Saturdays eve are over. At least with the big "coins". Apparently, the ECB discusses the abolishment of  500 Euro notes. well, well ....

CDS Implied Exchange Rates (again) (os)

I have already mentioned (here and here) the work on CDS implied exchange rates I did with my dear friend Arne Breuer. Additionally, you will now find a shorter version of our Applied Economics Quarterly article at the magazine section of Xaia Investment.

Basically, as I said, this a just shorter version of our Journal article, where we have dropped a lot of additional explanations (hence, you will have to read the whole article in case you want to get a deeper understanding :-). Yet, therefore we have extended the time line until the early 2013 to capture e.g. the developments of Cyprus.

Papers We Read: Financial Intermediaries and Monetary Economics (bs)

In our yesterdays session, we discussed another paper of Mister Shin, this time a piece he published with Mister Adrian:

Adrian, T. and Shin, H.S. (2011), "Financial Intermediaries and Monetary Economics", Handbook of Monetary Economics, edition 1, volume 3, pp. 601-650.

Here are some key findings:

It seems to be a stylized fact that shifts in the (short-term) policy rate translate directly into shifts in the slope of the yield curve. For this to hold, longer rates must be somewhat stickier than short rates. This is empirically proven by Figure 1 (p.604, see below), which states an almost 1:1 negative relation between changes in the fed fund rate and the term spread.

A higher term spread has important implications for the banking business because it increases its profitability. Hence, the future risk-taking capacity of the banking industry is fostered and thereby credit supply increases. That is, procyclicality in loan supply is explained by the variation of the slope of the yield curve. The risk-taking channel of financial intermediaries - effective also because the banking system is financed increasingly short-term and market-based - entails the policy implication that the short-rate is an important price variable on its own. This stays in contrast to the widely held view of monetary policy that short-rates are simply an instrument to steer longer rates, ultimately the ones that are relevant for consumption and investement decisions. Incremental variations in short-rates can have detrimental effects on a wide range of transactions made by market-based institutions. As the authors argue, for SIV a difference of a quarter percent in funding costs may make all the difference between a profitable venture and a loss-making one (p.605).

It remains a puzzle why financial intermediaries haven't realized those potential funding risks prior to the crisis. It also poses the question if monetary policy was aware of the amplification mechanism that arise because of bank's active balance sheet management. I assume, it was not. Nevertheless, the FED became increasingly tighter in the run-up to the crisis - argueably practiced some sort of "leaning against the wind policy", at least from  2004-2006.

Sadly enough, this tightening did not wind up risky short-term funding or made the financial system any safer. I guess, there is more to come...

How to Justify the Scientific Method - bit#*! (os)

Just Sciences

"Professor Richard Dawkins in conversation with Dr Stephen Law, senior lecturer at Heythrop College, University of London, discussing the major issues of importance to humanists and atheists at a time when opposition to rationalist thought appears to be on the rise. Filmed at the Sheldonian Theatre, Oxford, on Friday 15th February 2013"

CDS Implied Dollar Euro Exchange Rate (os)

Few month ago, I wrote about an article of my dear colleague Arne Breuer an myself about the CDS implied  Dollar-Euro exchange rate. Find it here.

Finally, I have made it, to update my data. For the picture below, I have included Cyprus. We know, the data is not that reliable due to the quite illiquid market, however, just to give an idea I show it. And despite these caveats, it becomes obvious, what happened, when Cyprus announced its problems in August 2012. There you firstly see a deviation of the CDS-fx from the actual fx. Yet, the gap closes soon, due to the size of Cyprus and also the re-alignment of the actual exchange rate.

Papers We Read: Procyclicality and Monetary Aggregates (cps)

The semester's over in Hohenheim and so is the weekly frequency of our paper sessions. However, we got around to another one this week and discussed a paper that's already been out for some time:

Shin, Hyun Song and Kwanho Shin (2011): "Procyclicality and Monetary Aggregates", NBER Working Paper No. 16836, National Bureau of Economic Research.

Abstract:

Financial intermediaries borrow in order to lend. When credit is increasing rapidly, the traditional deposit funding (core liabilities) is supplemented with other funding (non-core liabilities). We explore the hypothesis that monetary aggregates reflect the size of non-core and core liabilities and hence convey information on the stage of the financial cycle. In emerging economies with open capital markets, non-core liabilities of the banking system take the form of short-term foreign exchange liabilities, increasing the vulnerability to the outbreak of “twin crises” where a liquidity crisis is compounded by a currency crisis.

While we neither want to disrespect the authors nor South Korea as an economy, we found that the first, general parts of the paper were most notable and generously skipped some 'empirical' parts, considering them back-up for the ideas introduced before. Like that, the paper's a pleasantly short yet interesting read.

Melts In Your Mouth, Not In Your Hand (cps)

Fun news with minor policy implications: Canadian 50 and 100 Dollar banknotes apparently deform when exposed to heat, where 'heat' means as little as your car on a hot summer's day. I had so many stupid jokes planned out, but I guess everyone who reported about this already included some sort of pun. Therefore, I'll keep it short and end with a straight-to-the-point high-end-journalism quote: "I don't think the Canadian $100 bill should be weaker than two-ply toilet paper."

Papers We Read: The Run on Repo (cps)

Part of working at a university is, of course, to discuss what's going on in the profession. At our chair, this includes a (preferably) weekly session in which we discuss (preferably) current academic papers, largely in the field of monetary macroeconomics. While we don't claim to become (let alone be) agenda setters in this respect, we thought the readers of our blog, especially students who have already advanced in their studies and aim for more than just passing exams, might be interested in this as well. So here it is for this week:

Gorton, Gary and Andrew Metrick (2012), "Securitized lending and the run on repo", Journal of Financial Economics, 104 (3), 425-451.¹

Abstract: 

The panic of 2007–2008 was a run on the sale and repurchase market (the repo market), which is a very large, short-term market that provides financing for a wide range of securitization activities and financial institutions. Repo transactions are collateralized, frequently with securitized bonds. We refer to the combination of securitization plus repo finance as “securitized banking” and argue that these activities were at the nexus of the crisis. We use a novel data set that includes credit spreads for hundreds of securitized bonds to trace the path of the crisis from subprime-housing related assets into markets that had no connection to housing. We find that changes in the LIB-OIS spread, a proxy for counterparty risk, were strongly correlated with changes in credit spreads and repo rates for securitized bonds. These changes implied higher uncertainty about bank solvency and lower values for repo collateral. Concerns about the liquidity of markets for the bonds used as collateral led to increases in repo haircuts, that is the amount of collateral required for any given transaction. With declining asset values and increasing haircuts, the US banking system was effectively insolvent for the first time since the Great Depression.

¹ There's also an NBER Working Paper version in case you don't have access to the published article.

Happy Birthday ESM (os)

Here it is, Happy Birthday ESM. And, is it successful? Well, at least it finally pays to make debt. If you like to lend money to ESM you will have to pay (!) 0.0324% to ESM. If you like to give money to me you will have to pay 0.5%, cause I am at least as trustable as the ESM!

Mr. Crony Capitalism (amv)

Warum Spitzenpolitiker in Aufsichtsräten der Großindustrie sitzen, ist recht offensichtlich. Für Thyssen-Krupp hat sich nach Recherchen des Handelsblatts Peer Steinbrück eingesetzt: hier (HB) und hier (FAZ):

Der SPD-Kanzlerkandidat Peer Steinbrück hat in seiner Zeit als Thyssen-Krupp-Aufsichtsrat dem Stahlkonzern seine politische Hilfe für günstigere Strompreise angeboten. Das geht aus einem Protokoll des Aufsichtsrats vom 31. Januar vergangenen Jahres hervor, das dem Handelsblatt vorliegt.  

Während der Sitzung kritisierte ein Vertreter der Arbeitnehmerseite die hohen Stromkosten für deutsche Industriekunden. Steinbrück sagte daraufhin laut Protokoll, „wenn aus dem Kreis des Aufsichtsrats eine Initiative (...) ergriffen werde, sei er gerne zur politischen Unterstützung bereit.“ Als energieintensives Unternehmen würde Thyssen-Krupp von einer Senkung der Strompreise massiv profitieren.

Überraschenderweise:

Aufsichtsratschef Gerhard Cromme nahm laut Sitzungsprotokoll Steinbrücks „Anregung gerne auf.“ 

In diesem Zusammenhang lohnt auch die Erinnerung an Steinbrücks Rolle im Fall der West LB. Mr. Crony Capitalism eben.

New Year's Resolutions (cps)

I'm a sucker for cheap wordplays, so here's another one: Before we all lose our sober look tomorrow (ta-taaa!, now click the link ;), take a brief moment to think about what might be coming next year... Maybe it will be negative deposit rates for European banks so as to increase the incentive to lend out instead of just carrying funds obtained from ECB LTROs. A possible implication is the reduction of TARGET2 balances and a move toward financial re-integration because of newly sparked search-for-yield behavior. Another outcome might be that solid banks just pay back 'unused' LTRO borrowings and go on about their business (or even be better off?) for a while whereas not-so-solid banks... well, let's just exercise a little more and quit smoking. Guten Rutsch!


By the way, I wonder whether 'allocation' is a euphemism or synonym for 'search-for-yield behavior' and whether all of this could be part of 'safeguarding monetary policy transmission.'

NGDP targeting - we are (almost) there (bs)

Probably not just our dear colleague amv is all excited about the FED's new conditional QE3 program. In contrast to previous rounds of QE, now the FED announced to tailor its asset purchases to explicit targets of economic activity and inflation:

 [...] the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy [...]

As popular proponents of NGDP level targeting posit (here), this step comes very close to the desired policy change.

A rough estimate of Spanish recapitalization needs (ls)

I aim to provide a rough estimate of future losses of the Spanish banking system, therey pinning down its potential need for recapitaliziation out of ESM funds.  Data mainly comes from the Bank of Spain. I do not claim to obtain estimates accounting for endogenous feedback loops, it is rather a rule-of-thumb exercise which nevertheless sheds some light on the sufficiency of current rescue packages.

Total assets of Spanish financial institutions equal some €5.2 Trillion. The stock of aggregate credit is €2.0 Trillion. Securitiy Holdings amount to €1.2 Trillion. Roughly €400 bn of government debt is held by residents and probably €300 bn from financial instutions. 

How about losses from the stock of credit? The ratio of non-performing loans currently stands at about 10%, implying that €200 billion of credit are underwater. A commonly used benchmark for recovery rates is 40 percent, however, it is reasonable to assume an inverse relation between NPL-ratios and recovery rate since a large number of NPLs implies lots of liquidations which depresses collateral prices and hence recovery rates. I therefore assume a recovery rate of 30%. Additionally, one has to account for losses which banks yet have accounted for with the help of (dynamic) provisioning. I heroically assume that 33% of future losses are covered yet.

Thus, expected losses from the credit stock are: €200 bn x 30% x 67% = 40.2€ Billion

How about losses from securitiy holdings? By assumption, about 300€ bn of securities carry exposure against the government. Spains Debt-to GDP Level is projected to rise to 90% in 2013. Returning to the Maastricht criteria would call for a 33% haircut. Admittedly, this is an unrealistic worst-case scenario but useful for illustration. In this case, losses amount 100€bn.

Note that I abstract from potential losses out of interbank exposures. I do so because I assume that removing NPL-risk and haircut risk essentially removes the two main drivers of aggegate Spanish bank risk and stabilizes the system such that no interbank defults occur.  

Hence, total projected losses add up to 140€ bn. The financial system's aggregate equity position is about €400bn. So 35% are likely to be siphoned off in the next years, leaving the system with roughly €250 bn equity in relation to total assets of five trillion Euros, i..e the system would operate with a prohibitively high leverage ratio of 19:1. In order to avoid such unfavourable outcomes, European leaders agreed to inject €100 bn into the shaken Spanish banking system.

My rule-of-thumb calculation indicates this is very likely to turn out as insufficient. Clearly, my government debt scenario is very pessimistic. But note in contrast the exterme vulnerability of expected losses from credit against worsening recovery rates and worsening NPLs. It seems as we need an additional rescue package...

Thanks for the "Invitation", Hellas! (bs)

...ehm, or should I rather say: Thank you, EFSF?! Well, I'm not really invited, anyway. But those of you, who are, just some quick notes:

1. Show your greek debt at the entrance (max 10 billion)
2. To be on the guest list, send an email until Friday, 5:00 p.m. 
3. If you are still not sure how to get there, here is the map for you, guys.

Well then, have fun!

MTR vs. Deutsche Bahn (bs)

After a trip to Hong Kong last week, I'm very impressed with Chinese efficiency. Especially riding the metro is pure pleasure. The operating company is called Mass Transit Railway Corporation (or just MTR). In fact, the firm could really serve as a role model for our various underperforming Municipal Transport Services - just think of Berlin's infamous S-Bahn, DB's S21 or whatsoever.

Here are some facts. MTR is one of the most profitable transport companies of the world. Its annual revenue is about 800 million Euros. In terms of costumer service (literally everywhere in Hong Kong you can pay with MTR's Octopus Card), punctuality and reliability, MTR wins one award after the other. And although the company yields about one third of its revenue with ticket sales, riding the MTR is really cheap. After heavily using it for one week, I didn't spend more than 15 Euros. By the way, the remaining two thirds of its revenue, MTR makes running Shopping Centers and other businesses located around the stations.

As the rumour goes (Berliner Zeitung), MTR is considering to become an investor in Berlin's S-Bahn. Great news, one is tempted to say...

Greek GDP Forecast (os)

Just a nice picture I found via Sober Look: