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!

Weidmann calls for Capital Requirements on Government Bonds (ls)

He is very right. Please find the speech here.

Teaser (unfortunately only in German, emphasis added):

Banken müssen darüber hinaus aber stärker darin gezügelt werden, sich übermäßigen staatlichen Solvenzrisiken auszusetzen. Dazu muss die Bankenunion durch weitere regulatorische Maßnahmen flankiert werden. Zwei sind mir besonders wichtig, und beide zielen letztlich darauf ab, Forderungen an den Staat nicht länger gegenüber anderen bilanziellen Aktiva zu privilegieren: Erstens sollte es eine Obergrenze, eine Art Großkreditbeschränkung, für das Engagement einzelner Banken gegenüber staatlichen Schuldnern geben; zweitens, sollten Banken Staatsanleihen oder Kredite an den Staat entsprechend deren Risiko mit Eigenkapital unterlegen.

Die Eigenkapitalunterlegung von Staatsanleihen hätte noch einen weiteren Vorteil: Sie würde dazu führen, dass frühzeitiger Preissignale gesendet würden, wenn sich eine unsolide Entwicklung der Staatsfinanzen abzeichnet – es entstünde Druck zur Konsolidierung. Zusammen mit der gemeinsamen Aufsicht würde dies verhindern, dass Staaten trotz einer Schieflage im Haushalt weiter billige Kredite erhalten und so nicht nur sich selbst, sondern auch die Banken noch tiefer in Haushaltsproblemen verstricken.

Wie wichtig es ist, hier höhere Schranken zu setzen, zeigt die gegenwärtige Entwicklung: Es gehört mittlerweile zwar zum guten Ton, die enge Verbindung von Staatsfinanzen und nationalen Bankensystemen zu kritisieren. Angesichts der Geldnöte einzelner Länder ermuntern viele dann aber doch die dortigen Banken, immer mehr Anleihen des eigenen Staates zu kaufen.

Complex systems and simple regulation (ls)

As always, the recent Jackson Hole conference has been a source of excellent contributions. I find the speech of Andy Haldane most notably.

Some teasers:

Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity.

Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will. To ask today’s regulators to save us from tomorrow’s crisis using yesterday’s toolbox is to ask a border collie to catch a frisbee by first applying Newton’s Law of Gravity.

A tremendously striking result is displayed with the following regression:

Obviously, risk-based capital ratios - even though they are calculated with state-of-the-art risk management models -  have virtually no explanatory power for the probability of bank failure. A simple rule of thumb is clearly superior, namely a combination of the unweighted leverage ratio and GDP growth. 

Super Mario and the Bazooka (ls)

Todays meeting of the ECB governing council has been eagerly awaited. ECB President Draghi fueled market expectations of a large-scale government bond purchase programme with some statements given in London a few days ago (see here). However, todays announcements are vague and disappointing. Markets expected a 'Bazooka-Solution', Draghi rather gave them a shot out of a Super-Soaker-Gun.

I  believe that the concept of central bank independence and monetary policy from the ivory tower is not suitable for a crisis of unprecedented scale as we do witness right now. While political unification of the EMU is not feasible in the short run, the ECB needs to do a dirty job. Hiding behind legal concerns and phrases such as 'ensuring the functioning of the monetary transmision mechanism' is ineffective. Our central bank is compromising itself step-by-step. Starting with the relaxation of collateral requirements we came to purchases of both covered and government bonds. In fact, the term 'unconventional policy measures' is an euphemism. The ECB is actively engaging in fiscal policy, and the established frontier between government and central bank balance sheets becomes increasingly blurred. To be clear, I am not complaining about this developements. I believe that these steps are necessary. But they should be communicated in an honest and transparent way in order to remove uncertainty and to boost market sentiment.Let me make some examples from todays press conference:

The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible. 

What is a severe malfunctioning in the price formation process? Is the ECB showing sympathy for a theory of multiple equilibria on government bond markets à la de Grauwe? Does she believe that current risk premia show signs of exaggeration? How to decompose risk premia into solvency concerns and concerns about an exit of the EMU?  And what about financial fragmentation? Maybe fragmented markets with persistent spreads are the new fundamental? It is now well known that the virtually non-existent spreads in the pre-crisis regime have to be attributed to a considerable extent to undifferentiated collateral and capital requirements. And by the way: Recent LTROs fostered fragmentation, since PIIGS-banks acquired governement bonds with a considerable home bias, thereby further intensifying potentially adverse feedback channels between government and bank solvency. All in all, the statement above lacks of guidance and leaves markets and observers puzzled.

In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines.

Stressing conditionality again and again seems to be merely a lip service.The examples of Greece and Italy (Just remember Mr Berlusconi's reluctance to stick to his commitment to structural reforms after ECB interventions eased the refinancing pressure on his country!) show that conditionality is unrealisitic if not dynamically inconsistent. We rather witness dynamic bargaining processes which are constrained by political feasibility and the fear of disordered government defaults and their systemic implications.   

The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.

This is good news. But more details are needed. What about implicit yield targets? Any hints concerning the volume of this operations? What is meant by 'further non-standard monetary policy measures'? And seriously: It's not about ensuring price stability or repairing the transmission mechanism. It's about fixing this crisis. Quick. Let's hope that ECB communication will become more transparent and precise within the next weeks.  

Low yields - why and where? (ls)

The Economist published an excellent article on why yields in mature economies continue to be close to zero despite of rising debt ratios. Please find it here.

Key statements:

Add together the purchases of global central banks, domestic central banks (via QE) and financially repressed institutions, and well over half of British and American government bonds may be owned by investors who are relatively unconcerned about low yields. Mutual-fund and hedge-fund managers, more bothered about making a decent return, are thus hard put to play the role of vigilantes, so the state of the market is no longer the economic signal that once it was.

This division of bond markets into a premier league (of governments that can borrow at less than 2%) and the minor leagues (of those paying 6% or more) is a great advantage to those countries in the former category. America and Britain, in particular, can finance very high deficits (by historic standards) without feeling under pressure. Indeed, despite many years of current-account deficits, both countries have a surplus on their investment-income accounts, largely because foreigners earn such low yields on their dollar and sterling deposits and bonds. It is a neat trick: buy real goods and services from other countries and sell them low-yielding pieces of paper in return. And it looks like one that may have a fair bit of mileage left. Investors starved for choice may not relish yield-free bonds. But they seem likely to keep buying them.

The Euro as a Political Bubble (cps)

Investment grandeur George Soros gave an interesting speech at the Festival of Economics in Trento, Italy, a few days ago. He contends that European unification up to the introduction of the Euro resembles, on a political level, the formation of asset price bubbles.

The part-economic, part-philosophic foundation of his argument is that there exists no clear-cut 'reality'. Rather, there are trend developments and perceptions of these trends that mutually affect each other. In asset markets, positive trends may lead to overly optimistic "misinterpretations" (existence determining consciousness), which in turn reinforce the price rally and thus add to the 'reality' of rising asset values (consciousness determining existence). Once the "gap between the trend and its biased interpretation grows so wide that it becomes unsustainable", the bubble bursts---and it does so suddenly. Now his application to the Euro as the turning point in the European unification bubble:

"['far sighted statesmen'] recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble. That is how the Coal and Steel Community was gradually transformed into the European Union, step by step.

(...)

The process culminated with the Maastricht Treaty and the introduction of the euro. It was followed by a period of stagnation which, after the crash of 2008, turned into a process of disintegration."

Why? Because the next step of the political rally, movement towards a fiscal union, 'suddenly' seemed pretty far off when Angela Merkel declared protection of the banking sector a national instead of a common European concern after the Lehman insolvency in 2008.

He then asserts that there are roughly three months left, especially for Germany, to turn this around. If you're interested in

• how he derives the three-months window (Greek crisis climax in fall),
• what is to be done ("convincing commitment" concerning the banking system and peripheral refinancing costs),
• why the German public possibly prevents it (mistaking own past successes  for eligible solutions),
• and what could be the possible outcomes (German empire?!),

you can find the speech on his website. Read it---other smart people did, too.

DeLong on Knightian uncertainty and Keynesian liquidity preference (bs)

By comparing return differentials on TIPS and the S&P 500, DeLong calls for institutional reforms to mitigate The Economic Costs of Fear. Compelling argument: without efficient politics, there is no such thing as an efficient market.

"The hottest question in Europe" (amv)

is: "Did the ECB just pull off a Back-Door Bailout that will end the crisis?" by Simone Foxman. Reactions: Karl Smith, Modeled Behavior; Tyler Cowen, Marginal Revolution; Gareth Gore; Free Exchange (The Economist); Felix Salmon. I side with Smith and Salmon. Final update: Izabella Kaminska (FT Alphaville) resolves the issue (see also her previous post).

10 inconvenient Euro-truths by David Marsh (amv)

Excellent post by David Marsh (OMFIF):

Below are 10 key facts on the present position of the euro that many people overlook. Perhaps the most salient point concerns the direction of trade flows - the opposite of what you might expect. A classic case of ‘man bites dog’. The UK, a resolute non-member of the euro, has been busy over the past decade building trade ties with EMU. Yet Germany, in whose name and with whose currency monetary union was built, has been successfully integrating with the non-euro area – with fast-growing states in non-EMU Europe and Asia – and is doing progressively less trade with the euro bloc. Germany’s relative trade links with the peripheral countries have fallen particularly sharply. Considering these countries’ financing requires so much treasure from the taxpayers of Germany and other creditor countries, the imbalance between falling trade and rising demand for finance is at the bottom of the growing reluctance of the creditor countries to pledge more money to solve the conundrum. Confused about all this? Now read on.  

The ECB as Lender and Owner of Last Resort (amv)

I wrote a non-technical policy note on the sovereign debt crisis in the Eurozone. I argue that the only feasible as well as incentive-compatible solution to the current sovereign debt crisis in the Eurozone involves the European Central Bank (ECB)

• as a Lender of Last Resort to the Eurozone’s core countries like France, Austria, Finland, and The Netherlands, and
• as the Owner of Last Resort to the European banking system, thereby setting the stage for haircuts on the debt of potentially insolvent peripheral Member States like Greece, Italy, Spain, and Portugal.

Lars Christensen (The Market Monetarist) and Kantoos (Kantoos Economics) kindly published a summary of the paper. I am grateful to both of them.

Remark: It is argued that a proper management of NGDP-expectations would suffice to eliminate all distress on financial markets. Even though my paper argues that a shift by the ECB to an output-gap adjusted price-level-targeting regime is important to ease the debt crisis, I doubt that such a regime-change will be sufficient. One important reason is that there will be no return to the "old normal". Markets as well as regulators finally come to understand that there ain't no such thing like a "risk-free asset". The time of the zero-risk weighting rule is over. Positive risk-weights will remain, and so will higher equilibrium yields on sovereign bonds. It follows that recapitalization needs are real even in the case of perfect NGDP-expectation management.

Bond spreads and governance (ls)

Tito Boeri worte a nice piece on voxeu. He shows how the relative underperformance of Italian government bonds compared to Spanish ones during the last four months can be attributed to the different style of politicians in dealing with the debt crisis and nervous markets. It is not surprising that the obviously bad governance of the Berlusconi administration is found to be the main driver of rising spreads. 

Rogoff on Europe and the IMF (amv)

Click here for a very insightful article by Kenneth Rogoff. Teasers:

The IMF needs to bring much more of this brand of skepticism to its assessment of eurozone debt dynamics, instead of constantly seeking strained assumptions that would make the debt appear sustainable. Anyone looking closely at Europe’s complex options for extricating itself from its debt straightjacket should realize that political constraints will be a huge obstacle no matter which route Europe takes. 

Even outside Europe, the IMF has long given too much credence to sitting governments, rather than focusing on the long-term interests of the country and its people. The Fund is doing Europe’s people no favor by failing to push aggressively for a more realistic solution, including dramatic debt write-downs for peripheral eurozone countries and re-allocating core-country guarantees elsewhere. 

Now that the Fund has squarely acknowledged the huge capital holes in many European banks, it should start pressing forcefully for a comprehensiveand credible solution to the eurozone debt crisis, a solution that will involve either partial breakup of the eurozone or fundamental constitutional reform. Europe’s future, not to mention the future of the IMF, depends on it.

Since I don't see how the current incentive system can bring about a beneficial constitutional reform, we are left with Rogoff's other proposal: a partial breakup (check also Henry Kaspar @ Kantoos). 

Liquidity support leads to excessive risk-taking (amv)

Incentive systems play a pivotal role in economics (as I argue here). As already emphasized by Adam Smith, the extent to which markets translate 'individual rationality' into 'collective rationality' (i.e., the extent to which markets are 'efficient') depends on institutional configurations or, more precisely, on the proximity of actual institutions to the 'system of natural liberty'.  Mark Mink (© voxEU.org) applies neat rational-choice reasoning to 'show' that an institutional setting characterized by central bank liquidity support is likely to cause excessive risk-taking and, thus, is likely to cause (future) instability:

"Since the outbreak of the global financial crisis in 2007, and particularly since the bankruptcy of Lehman brothers in September 2008, central banks in their roles as lenders of last resort have provided large-scale liquidity support not only to individual banks, but also to the banking sector as a whole. [...] While these extraordinary measures were deemed inevitable in stabilising the banking sector, in Mink (2011) I show that the prospect of receiving liquidity support may distort banks’ risk-taking incentives to a much larger extent than has been acknowledged up to now. In particular, in addition to stimulating excessive maturity transformation, the prospect of receiving liquidity support provides banks with an incentive to increase their leverage, diversify their asset portfolio, lower their lending standards, and to do so in a procyclical manner."

In other words: there ain't no such thing as a free lunch!

Money is too tight! (amv)

I get increasingly upset with the ECB. I sincerely doubt that its monetary policy which persistently is 'behind the curve' (due to the ECB's refusal to target expectations) and discretionary is appropriate for edgy market sentiments all around the globe. It is frustrating that so many continental economists cannot identify that monetary policy is extremely tight at the moment (I guess, because most confuse low nominal yields with expansionary policy and because they do not trust their own models). Fortunately, we have Kantoos who provides an excellent argument for why, in fact, money is too tight in Europe.

His core statement:

It is time to realize that the policy of the ECB has been extremely tight since 2008, measured by the concept of macroeconomic stability and is therefore an important cause of the current mess.

Some Evidence:

Policy conclusion:

[...] The essence of this: choose a higher inflation, or even better, nominal spending target the more diverse (read: suboptimal) your currency union is. For the Euro area, an inflation target of below 2% is inadequate.

On S&P and the US-Downgrade (amv)

When it comes to rating agencies, I generically side with the view expressed by my fellow co-blogger ls. S&P's rationale for the recent US-downgrade, however, is somewhat unconvincing: it is not so much based on economic fundamentals (let us forget for the moment the $2 trillion error in calculating US discretionary spending that S&P conceded), but on S&P's fuzzy political judgement:

More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.

Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.

Ah, I see! But the expenditure orgies of President Bush Jr. justified AAA? I'm not sure, to say the least, if and to what extent S&P has comparative advantages as a 'public policy think tank'. I, for one, doubt that the extrapolation of the current political mess in D.C. is appropriate to justify the downgrade. More precisely, I doubt that S&P has a robust model relating the recent political turmoil associated with the insane Tea Party with US default risk.

As you all know, everything is relative. In economics, however, everything is even more relative! I still see no alternative to the deep and, thus, liquid US-treasury markets. Anyone in the house who really believes that the Eurozone is going to outperform the US? Politically? Economically? Further, the Swiss market is simply too small to house the global demand for (relatively!) risk-free assets. This is also true for our economically and politically sound Scandinavian neighbors. Or does anyone really believe that China or other Asian countries will outperform the US? In the next 10 years? Because they have better political systems?

Anyway, my scepticism is reinforced by the Economics of Contempt (HT Thoma).

UPDATE: Still relying on the EMH, I would be quite uncomfortable to make such statements without market backing. I don't believe that I'm smarter than the market. Markets, however, do accommodate my position as you can check here:

Source: Bloomberg

green: current yield curve

red: yield curve at previous close



Treasury yields have fallen along the entire yield curve! Two-year yields are on a record low! Bad news for S&P: your downgrade is not credible; you are detached from the market.

Sumner is back and rocks the boat (amv)

The opportunity costs of blogging are extremely high at the moment. This explains my absence in the last couple of weeks. The good news is that a much more able economists has returned to the blogosphere after endless months of absence:

Scott Sumner provides a very suggestive summary of his viewpoint on the GFC. As regular readers of 'the coffeehouse' know, I usually share his theory-based perspective. This time is not different. I especially like this: "The hero is the EMH [...]." I could not agree more.