Tuesday, 16 December 2008
Your choice on relative assets holdings will, of course, depend on the payoff in the various states. In the example below, the expected payoff from Asset A is 5 (10*0.5+0*0.5), as is the payoff from Asset B (2*0.5+8*0.5). So should you be indifferent between holding asset A or B? Not necessarily. Let imagine you decide to hold A, then you will receive either 10 or 0, when the state is revealed. Similarly if you decide only to hold B, then you receive 2 or 8, when the state is revealed. But if you hold 50% in A and 50% in B, then you will receive 6 or 4 when the state is revealed, which may be preferable to the outcome from holding only A or B. Note that your expected return across the states is the same and is independent of your allocation in this case but the variability of your payoff across the states can be reduced by choosing a combination of assets in inverse proportion to their variability. So if we choose 3/8 in Asset A and 5/8 in Asset B, we will have an income of 5 whatever the state turns out to be and this may be preferable to the alternatives.
The observation that an investor is likely to have mean and variance in his or her utility function won Harry Markowitz a Nobel prize in 1990. And there are a number of areas to which we may be able to apply these insights. Let us, for example, use this framework to think about the recent monetary policy problems facing the UK. It is becoming fashionable to argue that the Bank of England’s Monetary Policy Committee (MPC) should have responded in a forward-looking manner to offset the strong possibility of recession and so cut policy rates much earlier and decisively this year. Using our previous analysis would such a policy have been especially wise?
Imagine that Asset A is inflation and Asset B is output and payoffs are negative rather than positive. So the policy maker’s problem is to minimise losses by choosing an appropriate path for Bank Rate. So under X1 there is an inflation problem and something of a downturn and under X2 there is no inflation problem but a severe downturn. Should the MPC have kept interest rates mostly on hold, because of offsetting risks, until it was clear which state would obtain or taken a gamble and judged that X1 was simply not going to happen? In other words should the MPC have behaved like a speculator with his or her own strong prior beliefs and plumped for one outcome or the other? Or more like a portfolio manager and adopted a policy that delivers some stability in either possible state?
Some MPC members and one in particular seem to have adopted the speculator’s stance to go overweight on one asset rather than manage the possible portfolio of risks. Some might consider this to be a dangerous way to set policy because even though you may get lucky, and the inflation threat may dissipate, you may also get very unlucky and exacerbate the inflation threat. The MPC as a whole plumped for the portfolio approach. In the August 2008 Inflation Report (http://www.bankofengland.co.uk/publications/inflationreport/irspnote130808.pdf), the collective judgement of the MPC was that there were upside risks to inflation and downside risks to output and so like our portfolio manager they played it safe and did not move interest rates radically until it had become clear on which side the risks emerged.
The financial markets were perhaps more circumspect (!) than some MPC members. The chart below shows the five year inflation forwards calculated from the difference between the yield on nominal and index-linked (real) government bonds, which are linked to the retail price index (RPI). It is not a simple matter to interpret the inflation forwards as necessarily measuring inflation expectations as they may encompass either or both of inflation and liquidity premia. But if we hold those concerns to one side temporarily (and perhaps heroically), we can see a drift up in the expected inflation rate five years ahead from mid-2002, possibly reflecting concerns about the house price boom and second round effects from oil and commodity price rises. And throughout this year these inflation expectations also continued to drift upwards and it seems that only after end-August did these start to fall, and then somewhat precipitously. (Some of this fall seems relate to a flight to liquid assets as the financial crisis once again took a turn for the worse.) And that was the time interest rates should have started to fall as we found out that we were likely to have arrived in State X2. Since that August Report, Bank Rate has come down in three large steps from 5% to 2%, so what’s the problem?
Wednesday, 5 November 2008
The charts here show one well known prediction market run by Iowa University (http://www.biz.uiowa.edu/iem/). There were two US Presidential markets: the first for the respective share of Democratic and Republican votes and the second a winner-take-all market for the Party that would secure the greater number of votes. The vote share market represents the purchase or sale of futures on the Democratic or Republican share of the popular vote. On expiry, after the election, the future will be worth the fraction of US$1 equivalent to this percentage share. So, for example, early indications suggest that the Democratic share of the popular vote was 52% yesterday and so the price of the Democratic contract on expiry will be likely to be around 52 cents - meaning that anyone who bought at less than 52 cents or sold at more than 52 cents, prior to expiry, will make money. The official source for the liquidation price will be this Friday’s New York Times.
The first chart shows the prices of Republican and Democratic contracts since the contract started trading in June 2006 and we can see that apart from some glitches in May this year, there seems to have been a consistent lead for the Democrats, with some evidence of an increasing divergence since mid-September, after the collapse of Lehman Brothers. I do not have data on previous elections to hand but the consistency in the lead for the Democrats is interesting but so perhaps is the relatively small difference projected in the share of the popular vote. The spread of prices on the close Monday 3rd November data was 53.4-54.1 cents for the Democrats and 46.1-47.0 cents for the Republicans, which seems to have turned out to be reasonably accurate.
The second market is a simple horse race bet on which party will win the greater share of the popular vote with the all the pot distributed to those betting on the winner. In this case, the winner-take-all future is bought on either of the two parties at a discount to $1 with the sum of the prices equal to one dollar. The payoff on the contract, to those holding a future on the winning party, is paid for by the losses of those holding contracts in the losing party. Again the liquidation prices will be set by the report of the election in this Friday’s New York Times. So let us suppose that there was a 50:50 chance ex ante of either party winning the major share of the vote, this would be reflected in an equal amount of money being placed on either possibility and the prices of the two futures would trade at 50 cents. If this market felt that the Democrats became more likely to win, the price of the Democrat future would rise and that of the Republican future would fall. And in this case, as the Democrats have received the majority share of the vote anyone holding a contract for the Democrats, for which the price on Monday 3rd November close was 90.3 cents, will be paid $1 and anyone holding a Republican contract for which the price on Monday was just under 10c will get nothing and lose their stake.
The second chart shows a similar picture to the first, in terms of a consistent lead for the Democrats but also suggests that after the re-emergence of financial turmoil in September betting on the blue corner took a hold. With prices of the futures going from 53c on September 12th to over 90 cents by Monday morning, representing a 70% return in under seven weeks. Clearly Democratic Party Futures were the hedge against stock market turmoil. The prediction markets do seem to tell us that the Democrats were the most likely winners all along but it was perhaps only after the further bout of financial turmoil in September that this became very likely.
There are, of course, many reasons why we should not trust the signal from prediction markets completely. The financial stake may not be meaningful (in Iowa prediction markets investments are limited to between $5 to $500 per investor). Relatedly, liquidity may be low and prices thus too sensitive to lumpy trading. And the markets may simply reflect other evidence from opinion polls rather than promote a process of information discovery. But as a device for aggregating information across diverse individuals and for allowing a hedge against unwanted outcomes, these types of markets may well be able to help all markets become more complete. If you happen to be a Republican supporter my commiserations, but if you had also bought those Democratic futures at 53 cents in September you may not have felt quite so miserable this morning!
Friday, 31 October 2008
Let us examine the basic problem. Global savings equal investment at a single world interest rate (absenting risk). Figure 1 draws the equilibrium for the two country world of China and the USA, given their savings and investment schedules. In a closed economy, US interest rates would clear the domestic market for saving above R* and output would be determined accordingly. But when we open up to capital flows at the world interest rate, R*, the US expands its investment demand relative to savings, running a deficit, and at those interest rates China generates a current account surplus. The surplus (deficit) in each year adds (reduces) to net foreign assets in each year in the creditor (debtor) country.
The counterpart of savings excess in China is excessive investment in the US - recall that this comprises both public and private investment. Is a small reduction in US demand (investment) the answer? Not necessarily. Even if demand falls sufficiently to eliminate the US current account deficit at stable world rates, R*, then China would still have excess savings. This excess would drive rates down from R* and lead to the re-mergence of a current account deficit, albeit with lower world rates and a lower level of global imbalances. Obviously with large enough falls in US demand you could get zero current account balances in both countries at very low R and low US demand. Perhaps this is the solution, as we stare at a global recession, that we are heading towards?
We can also consider a number of alternative solutions. For example, a shift up in Chinese demand to clear the surplus at R*, at the original equilibrium, will mean excess demand in the US continues and thus world rates R* will go higher and there will still be a Chinese surplus and a US deficit. Obviously again if Chinese demand shifts up even further we can have no capital flows but at significantly higher world interest rates and high world demand. This may not be the solution we are heading towards!
The problem with this diagram as far as I can see is that any R can lead to an initial equilibrium providing China is willing to lend (or borrow) and US is willing to borrow (or lend). And what we learn is that if we want to adjust to some different level or direction of capital flows is that if only one country adjusts the overall change in rates and output will be greater than if they both adjust somewhat.
So what is the constraint or target? It must be something to do with the equilibrium level of net foreign assets to GDP and flows from one country to another to meet that target. The US is a debtor nation, (at around 6-7% of global GDP) implying that its current demand will be met by saving from higher future income. In this scheme (and I do not know the actual numbers but according to the IMF’s WEO Emerging Asia is in credit by around 5% of global GDP) then China will be the creditor. But for the reasons given earlier China should probably be the net debtor and borrow from its higher future income. And so if we are to get to a situation when eventually China becomes a debtor so capital flows downhill (from rich to poor), this will imply the need for a surplus in the US and a deficit in China, which implies lower US demand, greater US savings, higher Chinese demand and lower Chinese savings. But we probably knew that!
Thursday, 23 October 2008
A key additional finding is that recessions seem to have been unpredictable in real time, reflect changes in demand as much as any supply reductions and occur nearly simultaneously in major economies. Clearly the simultaneous occurrence of negative growth across economies might well be a candidate explanation for the severity, as trade multipliers will be running at full pelt. I do not know whether this recession will be a major one or not but the extent of the fall today in Sterling (closed on 22nd October 88.3 compared to previous day at 90.4 with Sterling falling over 6c against the US$ alone) and in the equity index (FTSE-100 and FTSE All-Share both fell by over 4%) suggests that the financial markets expect both a strong negative domestic interest rate response, which drags down sterling, and a large fall in corporate profitability, which drags down the equity index (recall that equity prices should be present value of expected corporate profits, which are in return a function of output).
In a speech on Tuesday, the Governor of the Bank of England gave two reasons for the recession. The credit market shock, which has deprived household and firms of liquidity against their collateral in some degree and so reduced demand, and a global price shock to fuel and commodities that has reduced household disposable income, rather like a large unanticipated tax rise levied by a foreign government. I suspect the financial shock has another consequence. The impecunity of the UK household balance sheet has been exposed - as perceptions of net wealth have been eroded with sustained falls in asset prices. And this means that the UK private sector balance sheet, currently well in deficit to the tune of around 5% of GDP, is certainly even more in need of a sustained bout of savings, which will surely reduce demand further.
The peaks in interest rates occurred sometime after the business cycle peak but there is no clear pattern in the interest rate troughs (as in the most recent recession, policy rates were constrained by ERM membership). When inflation was more of a problem, in the earlier recessions, interest rates did not move especially far in proportional terms – falling by around 25-30% of their peak value in both cases. But when inflation was reasonably under control, as in the most recent recession, interest rates fell by a much larger fraction, by around 65%. If we mechanically apply these boundaries to the current scenario, we arrive at a corridor for base rate at 4.00% to 2.00% as the floor this time round. Clearly the current consensus is for inflation to reduce radically as commodity prices fall in response to lower world demand and the increasingly large negative UK output gap drives down pricing power of firms.
And so we might conclude for the moment that the markets have priced more of the latter scenario in than the former and hence the large exchange rate and equity price responses we have observed. But as ever we shall have to wait and see what that rainy day actually brings.
Tuesday, 14 October 2008
In fact, as recently as this spring, I argued at a Public Policy Round Table that the state had already become too large and that during a sustained period of full employment growth a succession of government budget deficits, since the fiscal year 2002/3, did not make a great deal of macroeconomic sense. I argued that we needed a commitment to a smaller state and with it would come the room for manoeuvre the Bank of England would need to cut interest rates and offset the ongoing credit market shock. The sequence of deficits meant that the public sector net debt to GDP, excluding bank liabilities, was pushing pretty hard at the government’s ‘self-imposed’ target of around 40% to GDP. But the bail out of the banks now seems to have made my wish for a smaller state pretty unlikely as public debt looks likely to swell to postwar levels, which will in the longer term increase the incentive for a bout of sustained inflation and cause me to dust off my textbooks on the dangers of public ownerships and directed state action.
So how did we overturn the tide of history over a weekend and (partially) enact an infamous promise in the 1983 election manifesto of the Labour Party to nationalise the banking system? The short answer is that the banking sector found itself desperately short of capital and could not find sufficient funds from the private sector to raise that capital. The irony is that banks normally stand on the other side of this problem, as they are themselves reluctant to lend to individuals who need capital and ask for significant collateral or evidence of good standing before parting with any money. Or as many a businessman has put it, banks do not give out umbrellas when it is raining. But in this case, there has been no rain for a long time and a drought has resulted as liquidity has dried up and many of our banks have had no option but to buy some water from the largest reservoir in town: The State. For exercising that right to buy, they have given up a controlling stake in their future.
To recap, the UK government, in a plan that seems now to have been mimicked throughout the world, has taken preference shares (hybrids of debt and equity, where an fixed dividend rather than a profit share is paid to holders and where holders have senior claim on assets in the event of any liquidation) in three major UK commercial (or high street) banks. These preference shares mean that the government in return for an injection of £37bn owns over 55% of RBS and HBOS and around 43% of Lloyds TSB. The UK government thus has a (temporarily until the share are sold back) controlling stake in these banks. It has also offered to insure interbank lending for UK banks providing they re-capitalise privately or through the state. Recall that interbank lending has all but ceased and the interbank rate spread over LIBOR has shot up to reflect both liquidity and credit risk. The insurance, if appropriately priced, offered by the government should help eliminate the liquidity risk I would expect as a spillover also help to alleviate credit risk. Various extensions to the Special Liquidity Scheme have also been announced.
In sum these measures aid liquidity of banks and by shoring up capital allow them to have a cushion against losses and thus promote some semblance of confidence in the financial sector. All this has been required because having extended loans on the basis of relatively little equity capital, with the blessing of the regulators, the banking sector faced extinction of their equity capital from a number of possible avenues. That the default rates on loans would be higher than expected, that collateral held against those loans would be insufficient and that funding for those loans from short term deposits from households or the wholesale money markets would dry up. Given the interconnected nature of these events, it turned out that a shock to collateral triggered defaults which triggered mistrust in wholesale money markets, not only between banks but also between the net supplier of funds (pension and insurance companies) and banks.
So what we discovered was the correlated nature of these risks, that they were not independent events and that the scale of liquid reserve or capital that banks held against these shocks was insufficient. And so banks have to ratchet up their levels of capital to cover both previous losses and to have a sufficient liquid store of wealth against future shocks. The trick is to try and engineer this capital injection quickly so that lending can now resume in the face of a rainstorm...the banks need to giving out galoshes a well as umbrellas right now.
As far as temporary part-nationalisation of the banks, to coin a phrase: There Is No Alternative (for the moment).
Tuesday, 7 October 2008
Developments across European banks, starting with Ireland last week, really are quite disturbing. The unilateral guaranteeing of all deposits and Tier 2 debt is basically akin to the guarantee given by the UK government for Northern Rock last year after its bank run. But as we know this was insufficient to prevent its eventual nationalisation - as no buyer could be found. The guarantee stopped the run on the Rock as far as retail depositors were concerned but did not allow the bank to continue with its wholesale funding model. These recent decisions seem to have been made at the national level with no real consultation with the EC (and in this case the ECB) which as a side-issue will raise a pretty big question mark over co-ordination within the EU and the Eurozone.
But these or any guarantees do not address the fundamental problems of banks that have been far too reliant on wholesale funding and whose asset quality has deteriorated markedly. That problem has been replicated again and again in the UK and elsewhere in Europe. In the case of Ireland and Iceland it is also magnified as it is not one or two banks among many but the whole banking system which seems to have adopted the same model. A blanket guarantee does not help the quality of assets and hence funding liquidity - all it does is re-assure depositors (retail rather wholesale) that their money is as safe as the finances of the Irish state or Icelandic state.
So how much can individual European states help their banks? I plot here the ratio of the sum of major bank assets to GDP for the many of the main European nations (Source: http://www.ft.com/). The ratio tells us neither about the riskiness of each Euro of assets on the bank’s balance sheet nor about the capability of the state to capture its tax base, GDP, per se but does perhaps allow us to put the scale of the problems into some national context. And immediately we can see the scale of the Icelandic problem with bank assets at nearly 11 times GDP, where even a 10% default (if it was backed by the state) would increase public debt to GDP by nearly 110%. Under these circumstances the blanket guarantee would simply not be credible, as an increase of debt-GDP permanently of this size will require a permanent increase in the primary fiscal surplus by some 2-3%!
We also learn that Irish bank assets to GDP are around 250%, which is only around the Eurozone average (obviously not the UK, Iceland or Switzerland) and tells us that in asset terms the Irish banking system is perhaps no larger (or vulnerable) than that of the EZ average. But the extent of the fragility, which despite not having an excessive level of asset creation by international standards, was such that a government guarantee was required. And the need for this commitment device tells us something important about perceptions about the quality of bank assets and the likelihood of continuing funding.
The extent of heterogeneity of individual countries bank asset size is interesting and of particular note is the relative strength of the German state with respect to German banks with major bank assets at only around 140% of GDP. And that even though Italy looks superficially well off the raw number of 170% does not probably deal with the relatively poor credibility of the Italian fiscal authorities, where the provision of a guarantee may be proportionately more difficult. (That said the lending there may not have been quite so risky.) So even if the Irish and others have dealt with their banking stress with a government guarantee - if a scheme of this sort was to be extended to the whole of the Eurozone it is likely to need the guarantee of the German state.
This situation is not unlike trying to devalue a currency within a fixed exchange rate zone. The analogy is that other countries will not be happy with the unilateral increase in relative competitiveness. And there will be some pressure for a further round of devaluations (guarantees), which we have now seen. Most obviously those countries who are most vulnerable and whose assets are closest substitutes will be under most pressure to give a similar guarantee. And again that is what we are now seeing.
Given the juxtaposition of dwindling deposits and deteriorating assets, I would expect governments to will want banks to increase their Tier 1 capital, if at all possible, and that may mean some deals to be struck with Sovereign Wealth Funds and also perhaps the need for governments to take a direct capital stake in banks. Bank mergers will also be a regular event as the market compresses. But given that the root cause is poor quality assets, this may only be the first step on the road to a proliferation in TARPing or some form of insurance support for assets as well as liabilities in the Eurozone and elsewhere. The onus of the government or the public sector as a solution to the immediate crisis will mean that nation-states look likely to become inextricably linked to banks once again but this time as creditors.
Monday, 22 September 2008
The financial crisis has dominated the headlines for over a year now and provided a chronic migraine to bankers, policymakers and academic economists as we try to locate the causes, cures and consequences of this crisis. Whilst I am not going to provide a definitive answer in this column (yet), what I think I can do is set the scene in the first instance about some causes of this crisis. I will deal with some other aspects in future weeks.
Early commentary on the current financial crisis treated it as a necessary re-pricing of market risk and it is still difficult to disagree with that basic point. Promulgated by the emergent-saver nations, such China, world interest rates fell in the past decade or so. And taking a lead from Japan and then the US, the early years of the 21st century had been characterised by low policy rates, which were accompanied by a widely-offered argument about the possible end of the business cycle and a series of innovative ways for the financial sector to expand the liquidity of financial intermediaries. All of which perhaps contributed to a sense of hubris or infallibility within the financial sector and in the wider economy and certainly a sense that risk had somehow dissipated. Accordingly, the price of risk fell as likelihood of bad outcomes was collectively judged to have fallen markedly.
Under these circumstances, asset prices could not help but be bid up and the risk premia required by investors to hold various classes of risk evaporated. High asset prices provided the means for further liquidity creation for the private sector, as owners of capital and homes found themselves with bankable quantities of equity. They also provided an impetus to financial engineering, with liquidity combining with a search for yield to produce new methods of handling the consequences of financial intermediation. Banks found that they could borrow their liabilities increasingly from other banks rather than from arguably more reliable retail customers and create loans (assets) that would amount to many times their underlying level of capital.
The relaxation of credit constraints provided a boost to economic activity, which might typically have been managed with a temporary increase in policy rates to ensure that demand did not run away from the gradual increase in supply. But at the same time there was a deflationary impetus from newly industrialising economies that placed downward pressure on traded goods inflation. So that inflation targeting, in some cases quasi-inflation targeting, central banks did not feel that it was necessary to raise policy rates to a sufficient degree. And so the long expansion, or what we might eventually look back upon as a boom, continued unabated.
It was argued that the overall risk from extending loans could be mitigated by more sophisticated forms of risk management (which we will explore in future weeks). But as loans are extended to more and more agents, the quality of the marginal agent – in terms of ability to repay - will at some point deteriorate. Escalating debt levels and greater coverage of loans amongst a given population leads to two possible sources of instability, that the private sector expectations about the path of interest rates and the growth of future income have been too optimistic and that the asset price-based collateral used to back a given loan may deteriorate. The former will make debt service more difficult and any downward shock to asset prices will increase the implied level of gearing for any loan and so threaten net worth. And so it would seem that higher levels of more widespread debt may actually tend to increase overall market risk.
To some extent this is indeed what happened. Even though risk was spread amongst many financial institutions many of the original loans became riskier. So we ended up with a position of low market rates, high asset prices and escalating rather than declining economic risk. The trinity is impossible and something would have to change and in this case it was the first two relative prices. Banks and private individuals both had to re-assess the viability of their balance sheets and seem to have come to a similar conclusion that capital and savings have to increase. Households may be able save, if their income flows are maintained but that is a big if, but banks cannot re-capitalise when liquidity is low and so governments came to the rescue with a fiscal bail-out.
To some extent the crisis has finally come to a head in the past week. The recent bail out of two large Government sponsored enterprises, Fannie Mae and Freddie Mac, the bankruptcy of the once-venerable institution Lehman Brothers and the take-over of HBOS by Lloyds TSB. It seems likely now that the as well as continuing to offer short term liquidity to help banks finance their ongoing operations, there will be some attempt by the US authorities to buy up the bad assets from banks who own them at a deep discount and hope fully try to develop some form of secondary market for these assets.
If we are now to move from a regime of easy money (low interest rates, low inflation, high asset prices and high gearing) to one of tighter money (higher interest rates, higher inflation, lower asset prices and lower gearing) what are the implications? By which I mean what will the landscape of the financial and banking system look like, how will it be regulated and how will the transition from one regime to the other be managed.
In a market economy, with collateral required for lending, raising the required rate of return on marginal projects will reduce the level of capital employed in the long run and hence the rate of economic growth. So we will have to transition to a lower than expected level of growth. The transition will probably lead to a public and private debt overhang, along with further possible bail-outs for the financial sector. And the danger is that this will change the terms of trade for monetary policy, particularly as deflation will have to be avoided, with a strong inflationary incentive re-emerging. Tighter regulation of the banking and financial sector will be difficult to avoid and so we may end up with an economy that ultimately is less reliant on the financial sector for its growth, I am not quite sure that lower growth, higher inflation, higher taxes and a less dynamic financial sector will be preferred by all. But if the alternative is occasional busts on this scale, there may in fact be little alternative, even if we did mostly enjoy the ride.