Aatosekonomi

Is euro overvalued?

2010-11-07T16:54:00.000Z

“There is only one route for the euro, towards 1.08 in the US dollars by the end of this year and towards the eventual parity in 2011”, forecast an expert in a TV interview during the heydays of the euro crisis in the beginning of June 2010. The actual exchange rate was then 1.20 US dollars per euro.

Only two years before, in May 2008, when the euro hovered at 1.55, another currency strategist forecast: “there is only one route for the US dollar, towards 1.70 by the year end”. Incidentally, the euro touched 1.25 half a year later – and 1.50 in subsequent November in 2009.

Forex-strategists may in passing mention purchasing power parity (PPP), but most often emphasize short-term trends that may not at all be based on a convergence towards PPP but on recognition by technical analysts, that is, by those who try to find out recurring patterns in the historical data. PPP is a theory of the intrinsic value of a currency: the equilibrium exchange rate equates the cost of an average goods basket in the two currency areas. When PPP holds true, a dollar or a euro buys the same basket irrespective of the country where it is expended.

The best available estimate for the correct long-term value of the euro in the US dollars is based on the average goods basket of the OECD countries as calculated by the Ifo Institute in Munich, Germany, the most recent value of 1.17 being published in CESifo Forum 3/2010, p. 39. Were the US basket the reference the parity of the two currencies would roughly represent the PPP indeed. And in respect of the German basket, the PPP value is not far from the current exchange rate of 1.40.

The euro zone contains countries with a lower level of general prices than in Germany. Hence the rise of the euro to 1.55 in 2008 may not have represented any drastic overvaluation in terms of the euro-zone basket of goods. In fact, during the Carter administration the US dollar was much weaker, about 1.70 dollars per euro.

The preferred OECD purchasing power parity of 1.17 in contrast to the current exchange rate of 1.40 implies about a 10 per cent overvaluation of the euro. But, how quickly does the exchange rate of a currency converge to its PPP value?

The established robust econometric result during my life-time of teaching was that any discrepancy from the PPP would be halved over the medium term which most researchers interpreted as anything from one and half years to three years. From this perspective the forecast for the dollar exchange rate of the euro for November 2011 is that the euro would slightly depreciate against the US dollar. – And experience shows that we will experience much wider fluctuations.

This leaves ample room for the real actors in the currency (forex) markets: find a trend, trade the trend, and ride the trend. For a forex trader a trend in an exchange rate is like bureaucracy: it does not pay to fight against it.

Stress test

2009-03-31T13:45:00.009+01:00

Why does mayhem in world financial markets continue without a clear sign of ending? Why recovery of real economies delays? Economists seem to join lemmings in the political market and to succumb to its guiding forces, populism and opportunism, in their proposals to implement tighter regulation of financial institutions and looser budgetary policies. Shouldn’t they rather stick to the basic body of their science?

When politicians slightly open the strings of their purses, it pays for the actors in private markets to delay their decisions in the hope for milking more generous subsidies and expenditure programs. That is why sound fiscal policy would now call for an end of constructing new such programs. The worldwide downturn will anyhow immensely deteriorate public budgets through automatic forces, by reducing tax revenues and increasing social transfers because of stalling production and enhanced unemployment. Thus lesson no. 1 is that a responsible piece of economic advice would not only limit public budgets to their present stance but would also kill the option to delay in taking private action.

In monetary policy, central banks have largely emptied their ammunition, steering rates of interest set at their historical bottom; quantitative easing remains, i.e., central banks buy unconventional assets from the banking system to directly create loanable reserves.

Only the ECB has room for additional maneuver in its steering rate. – You guessed it! I do not recommend the ECB to cut the rate of its main lending facility on April 2. In the current circumstances it is time for thinking about future; price developments in the euro zone, the harmonized index of consumer prices rising 0.4 per cent in the month of February, are not encouraging for a rate cut. The lags of monetary policy are notoriously long and variable. Sticking to the most basic lesson of monetary policy – inflation is always and everywhere a monetary phenomenon, lesson no. 2 – would kill the option to delay the start of lending by big banks.

The “too-big-to-fail” –doctrine is not economics but sociology of economic policy. Politicians and their economic advisors should abandon it in favor for admitting the fact that in mayhem, as the current one, all financial institutions are zombies if strict mark-to-market financial accounting were applied to them. Therefore no kind of discretionary cleansing of banks from their bad loans would make the system safer.

The banks were lured to risk taking by regulation itself, by the incentives that softened the impact of regulatory red tape on them. And, those incentives were hugely fuelled by the Fed’s lax monetary policy since Alan Greenspan’s acclaim “irrational exuberance” - acclaim because he did not act accordingly.

Banks are currently passing through a real stress test. Therefore it is irresponsible economic management by the ministries of finance and by the central banks if they try to benefit from the difficulties of the banks. Rather, I would see the ministries of finance advancing credit on equal terms to every bank regulated by the Fed and the ECB at the same interest rate as the governments can raise themselves. But after a two year’s grace period, a progressive penalty rate over the next 5-7 years need be applied to such loans to recover the taxpayers’ funds. Banks and individuals will react to changes in relative prices; so, lesson no. 3 is that let the markets decide which bank will fail and which stay.

Lesson no. 4 is to get rid of other kind of bank regulation, except for requiring the top managers and the major owners of the banks to be fit-and-proper professionals, in the first instance, and for preventing them from looting their banks in case a bank will walk plank. Part of such preventive rules would be to install a claw-back clause on the managers’ future compensations so that their remunerations will retrospectively - perhaps over the last five years before a bank failure - be reduced to a decent benchmark.

Bad “bad bank”

2009-02-11T10:07:00.007Z

The task of a bad bank should be to sell their good assets to the good banks and to other potential buyers as to the “vulture” funds. When Chairman Bernanke’s approach is followed: “to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank”, we get exactly the incentive problem that caused yesterday’s jitter in the markets: how to value the toxic assets. The pricing of such asset categories too low would make many big banks insolvent while purchasing at an inflated price above market values means the taxpayers handing a subsidy to the banks.

In the banking crisis of Finland in the beginning of the 1990s, the “bad banks” were fallen angels, banks fallen to the control of the government, which sold their good assets to the remaining healthier banks and to foreign financiers. Thereafter the bad banks managed their portfolio of sour loans and real estate holdings as every bank is accustomed to do.

Pretty soon after the first fallen angel emerged, all banks were offered a capital loan on equal terms in proportion to their risk-weighted assets and off-balance commitments. Such funding was junior enough to count as tier I capital: interest could only be paid after the receiving banks had fulfilled their other commitments, but dividends on preference shares and common stock could be distributed after the banks had paid interest on the capital loans.

In practice, the government’s capital loan offer funded “mating”. During the consolidation process the banks were able to raise private co-finance, both equity and long-term debt, in the financial markets. Those banks that did not find a stronger partner ended up as bad banks.

Besides the customary political process, the delay in solving the Finnish banking crisis was caused by the lack of a government agency that received fallen angels. But, the USA has an experienced government agency for that purpose, the FDIC.

US Treasury Secretary Geithner need allocate the remaining TARP funds to the FDIC. What the USA is lacking is a government offer for funding that would facilitate the amicable mating ritual on equal terms for every partner.

It is not the purpose of a government agency to profit from solving the banking crisis. It was astounding to read in today’s press Chairman Bernanke to have announced yesterday that the Fed expects to make big profits from its increased role in the credit markets.

The task of the Fed and other federal agencies is to breathe new life to the speculative confidence of private actors as well as strengthening credit creation. This follows from Keynes’s analysis in Chapter 12 “The state of long-term expectation of his General Theory (p. 158): “the recovery requires the revival of both”. The whole chapter eloquently covers the difficulty of valuing long-term investments in the stock market.

Preventing the world from central bankers’ ego

2009-01-19T22:34:00.005Z

Instead of Keynes, would the old Friedman rule be worth studying again? Milton Friedman invented his rigid rule for monetary growth to save the citizens of a free society from the central bankers’ ego unlike Lenin’s instruction to most effectively destroy a society by destroying its money.

Friedman was fearful of “the assignment of wide discretionary powers to a group of technicians, gathered together in an ‘independent’ central bank” and wanted “to establish institutional arrangements that will enable government to exercise responsibility for money, yet at the same time limit the power thereby given to government and prevent this power from being used in ways that will tend to weaken rather than strengthen a free society”; Capitalism and Freedom (1962, p. 39). Friedman introduced the idea of a constant annual rate of growth of money stock, regardless of changing economic conditions, to curtail the discretionary power of the monetary authorities in A Program for Monetary Stability (1959).

“The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than any inherent instability of the private economy”; the Federal Reserve System exercised its power to conduct monetary policy “so ineptly as to convert what otherwise would have been a moderate contraction into a major catastrophe” (C&F, p. 38).

By Friedman’s hindsight, the error list of the Fed included the unusually tight monetary conditions since mid-1928 culminating in an attempt to curb “speculation”, but leading to the 1929 stock market crash - that is, the Fed pricked the bubble which Greenspan’s Fed declined to carry out; the money stock declined by nearly 3 per cent from August 1929 to October 1930 – “a larger decline than during the whole of all but the most severe prior contractions”; prior to October 1930, there had been no sign of a liquidity crisis, or any loss of confidence in banks, but thereafter the economy was plagued by recurrent liquidity crises, runs on banks and waves of bank failures, but the Fed “stood idly by” because of “will, not of power”; Britain went off the gold standard in September 1931 inducing gold withdrawals from the USA, but two years of severe economic contraction did not prevent the Fed from defending the dollar and ending the gold drain by raising the discount rate – the rate at which it lent to member banks; the US money stock fell by one third from July 1929 to March 1933 with over two-thirds of the decline after Britain’s departure from the gold standard.

No wonder, Friedman wanted to avoid important policy actions being “highly dependent on accidents of personality” by introducing his rule of money growth that would also prevent monetary policy from being subject to the day-to-day whim of the politicians.

Was Alan Greenspan’s ego too big because of Friedman’s infamous research on and critique of the US monetary policy of the 1930s in A Monetary History of the United States 1967-1960 with Anna Swartz (1963)? Did Alan want to show how the Fed’s errors of the 1930s can be avoided? Alan fought preventively against “deflation”, a continuous downward spiral of prices and wages, in 2003-2005 during the most rapid global economic growth ever experienced! Greenspan’s Fed ridiculed active monetary policy by inventing to raise the steering rate of interest at a “measured” pace – the flip side of Friedman’s rule of a constant rate of growth of money supply?

What went wrong? The world is a global village was already taught in the mid-1960s. With a number of emerging market currencies pegged to the US dollar and the pound sterling and the euro shadowing the US policy rate changes, the USA is no longer a small open economy. The Fed ought to have a surveillance of monetary and fiscal conditions in the whole dollar block, not only the US economy, before taking decisions.

Also, the new rule of raising the steering rate at a “measured” pace softened the signal of monetary policy to the market participants in contrast to the previous policy actions and greatly increased long-term uncertainty about inflation and interest rates though making the next policy step more predictable - and lulled all financial journalists as well.

Is Ben Bernanke’s ego also too big? He earned his academic credentials by research on the Great Depression, lectured as a Governor of the Fed on quantitative easing, Deflation: Making Sure "It" Doesn't Happen Here, by using the balance sheet of the Fed. He is regarded as THE expert on financial crises, on exactly those sequences of events the world has experienced during the past two years.

This crisis has shown that Keynes's green cheese, money created by the banks and other financial intermediaries, is no substitute for the US treasuries in case of real excess demand for the “moon”, currency and highly liquid government bonds. So, global imbalances and their financing patterns matter for monetary policy.

Friedman confessed in the 1986 Economic Inquiry that his “rule” did not satisfy the most basic incentive scheme because it was not in the self-interest of the Fed hierarchy to follow the hypothetical policy of such a rule. But in the end, Friedman was after getting rid of the whole Fed: private markets would deliver financial and price stability at equal or less resource cost.

From Regulation Failure to Non-Regulation of Banks

2008-12-14T10:46:00.003Z

Regulation of banks was never before based on such a sophisticated system as during the past 20 years, from the solvency rules of Basel I and Basel II to internal risk-metrics of individual banks. Yet we have seen banks gone bust as for centuries earlier. Also, there is nothing new in bailing out banks with taxpayers’ money.

Sveriges Riksbank, today’s central bank of Sweden, was in huge difficulties in the mid-1760s after having during the so-called Freedom Era extended credit to the merchants of Stockholm the most of which had gone sour. The difficulties were preceded by years of rapid inflation, credit growth and money printing. But, because the bank operated under the guarantee of the Parliament (Sweden had a parliamentary system at that time) it was of course gradually rescued by the taxpayers’ money. The years were politically stormy, two main parties competing for power. But in the end, a “third party” - the king party - won so that King Gustav III could again re-establish an authoritarian kingdom in a bloodless revolution in 1772.

Today the Federal system has assumed functions that traditionally do not belong to a central bank. It has purchased commercial paper issued by big US companies, for example. So the next “too-big-to-fail” institution may be the Fed; Obama’s Court, please be beware of! The situation in Britain and Ireland may essentially not be very different from the US quandary.

After regulation failure of the current scale, a tighter regulation hardly is the course to be followed as pointed out by immediate popular comments; tighter controls would not have prevented East Germany from collapse because German Democratic Republic did not exist.

If effective regulation of banks does not exist, why not consider shifting to a regime of non-regulation?

Regulate banks and other financial institutions only when they are granted their operation permit, but with the obligation to participate in the rescue of any failing member of banking business. This would internalize the costs from aggressive business strategies of one member. Any bank that walked over the bridge for lender-of-last-resort funds would know it to be the end of its business as an independent operator.

The banking business would thus operate under a mutual guarantee.

The task of the regulators would only be to promote transparency in banking, for example, by requiring banks and other financial intermediaries to publish their balance sheets every month in the main national and local newspapers.

Taxpayers’ greed will retard growth. Music started!

2008-11-07T10:48:00.003Z

The UK and US Treasuries succumbed to taxpayer populism and set too demanding conditions on the preference shares acquired in the partially or wholly socialized banks so that the banks would concentrate on purchasing the stakes held by the governments and that the taxpayers’ funds would be reimbursed without losses.

A 10 percent dividend yield on such shares is well above any long-term real rate of return on equities. Therefore the banks will maintain the present high margins on their lending to businesses and households to safeguard that the governments receive their dividends and that no additional socialization (nationalization) will occur. But, high margins on lending rates of interest will also prevent the economies from a quick recovery. That is, the taxpayers’ ultimate investment losses will only convert into a slower rise of their living standards.

Of course, there is the other route. The contracts are in nominal terms. Therefore by setting on a higher rate of inflation over the next five years or so, the governments can erode the real value of their claims in the banks but to secure a nominal capital gain on the taxpayers’ investments. That is why music started again – the recent aggressive cuts of the steering rates all over the world.

However this route causes additional losses in the financial system by melting the bubble in the government bond prices which further retards world growth, because the losses can only be covered from operating cash flows of the basic lending business; see trough of the US debt crisis.

Farewell inflation targets! Goodbye independence of central banks!

PS. Alternatively, the governments could have advanced amicable cannibalism within the banking sector by granting access to the government loans on equal terms for every regulated bank, but with less government money at risk.

The Lesson of the Financial Crisis

2008-10-20T15:34:00.003+01:00

Would tighter control have prevented East Germany from collapse? An analogous lesson to avoid future financial crises is currently offered all over the world by both professionals in financial stability and all-round intellectuals, in particular.

Of course, there were skeptics who did not believe in the Fed funds rate cut of 18 March 2008 as a healer of the credit crunch: why an additional dose of the same drug, low nominal and real rates of interest which was behind the excessive growth of credit and money. There are possibly fewer skeptics who see the on-going crisis as a consequence of the regulatory system of banks.

Any effective measure of regulation creates its own counterforce that tries to nullify the initial impact of regulation because inventive individuals are always clever in finding out ways to circumvent the constraints set on them. Solvency regulation of banks is based on the risk-weighted assets in the balance sheet of a bank that must be matched by the minimum of the so-called tier I capital, i.e., equity in practice.

Because equity is an expensive source of funding the simplest way to avoid issuing new equity is to reduce the size of the risk-weighted balance sheet in respect of a growing loan book. Therefore the US financial institutions transferred the risky loans off balance sheet by the originate-to-distribute practice. Though in Federal Reserve Chairman Ben Bernanke’s words the model "broke down at a number of key points, including at the stages of underwriting, credit rating, and investor due diligence," he believed in fixing the model April 10, 2008. My Green cheese factories post explained why the credit risks were not transferred off balance sheets in the end and why recapitalization of the financial institutions quickly would help the central banks to fight the inflation problem.

An additional means to reduce the size of the risk-weighted assets is to buy insurance for the loan book which contributed to the exceptionally low world interest rates. AIG, an established and profitable insurance company but a novice in evaluating credit risks, was the biggest underwriter of such deals, i.e., the final counterparty that was supposed to bear the risks of mortgage defaults.

Perhaps the final feature of the US system which so abruptly ended the music playing is that their mortgages are non-recourse loans. Such a legal contract gives the borrower the incentive for walking away from the mortgage whenever she expects the value of her house to remain below the value of the mortgage. After the repossession of the collateral, the mortgage will no longer be the borrower’s problem, but the bank gets an additional problem from the realization of the house.

Imagine yourself as investing the extra cash of your bank in short-maturity mortgage backed securities to awaken next morning to the fact that your over-night investment returns a capital loss. You would immediately lose confidence in the issuer of the securities and in all those middlemen who originally helped in its issue. That is why short-term money market rates of interest, libors and euribors, shot up well above the steering rates of the central banks.

Tight solvency regulation of banks combined with low steering rates of central banks is at the root of the current crisis.

One policy comment focuses on tighter regulation, another on better regulation and a third comment on border-crossing regulation in preventing the world from future crises. East Germany was controlled by border-crossing military forces. They did not prevent it from collapse, though choked down uprisings.

The US bill for a “bad” bank

2008-10-02T04:35:00.001+01:00

George Soros also favored the recapitalization of the US banking system in yesterday’s FT rather than relying on the purchases of bad “assets” from the US financial institutions. In Paulson’s plan the bad assets are not real assets but “toxic” packages of claims to real assets. That is why the acceptance of Paulson’s plan will not end the game, but allows it to continue.

In the best tradition of Stalinist central planning, the bureaucrats will continue to decide which institution has no perspective (Lehman Bros) and which will have (AIG). Paulson’s plan does not attract co-financing from existing or potential new investors in the troubled institutions unless the bureaucrats are known to treat the institution in question very generously indeed.

That is why Paulson’s plan will be expensive for the taxpayers, driving the US dollar to a state of permanent undervaluation.

Modify Paulson’s plan!

2008-10-01T11:48:00.003+01:00

Do not offer to buy bad assets from financial institutions but offer them capital infusion, Mr. Treasury Secretary! Cannot you invent any fiscal incentives for the first-time homebuyers that would re-vitalize housing market?

Events of the current financial crisis unfold very quickly - during those days and weeks spent abroad or in the outback, in particular. That is why I have had no comparative advantage over financial press to comment the process.

Paulson’s rescue plan rejected by the House would have given the bureaucrats broad powers to buy mortgage backed securities from distressed financial institutions at deeply discounted prices. That is, the bureaucrats would determine in casu how big a hidden subsidy each deal would involve for the seller institution.

Why cannot the banks and other financial institutions themselves trade such assets at market prices? They lack strong enough financial muscles.

The idea of recapitalizing financial institutions in the April 21st post stated that only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.

Since nationalizing Freddie Mac and Fannie Mae less than a month ago, the US Treasury has been subject to wide criticism for rewarding short-term players, short sellers, by nullifying the existing long-term value investors’ equity stakes. On this chosen road no private sector investor will participate in the recapitalization of any US financial institution.

US Treasury must do it itself by offering convertible notes which would count as tier I capital for the institutions. All banks subject to federal regulation should be eligible for accepting such an offer of capital infusion in proportion to their size, measured by their risk-weighted assets and off-balance –sheet commitments as stipulated by the BIS standards. The total of the capital offering of the size of 200 billion dollars, about 1.5 percent of the GDP, is roughly needed.

And, the terms should such that the offering would be attractive enough even for the most solvent and most liquid banks: a seven-year note, the first two years at the current interest rate on the 2-year US treasuries (about 2 percent), the third year interest rate at Libor, and thereafter each year at rising penalty rates above the Libor.

Such terms would buy time for settling the crisis. The offer of capital would provide the strongest institutions enough power not only to acquire assets at market prices from the weaker ones and to raise additional tier I and tier II capital in financial markets, but also would offer them an incentive to pay back the notes to the US Treasury before the convertibility carver threatens their independence.

Instead, the taxpayers’ money should be directed towards attracting buyers to the housing market. Buyers flee the market if they expect home prices to further fall. The most obvious target group, mentioned most often, is the first-time buyers, whether they intend to buy new or existing homes. There must be ways of temporarily granting a more generous mortgage relief or deducting one-off expenses from taxable income.

The above scheme would represent a market solution to the current crisis of financial markets in contrast to Paulson’s plan of giving power to the bureaucrats, i.e. to the central planners.

(Incidentally, I happened to participate in settling the Finnish banking crisis as deputy member of the board of the Government Guarantee Fund)

Defunct economist and price stability

2008-05-13T21:49:00.003+01:00

The defunct economist whose slaves today’s practitioners of price stability are is Keynes himself!

The infamous, eloquent ending passage (p. 383) of J. M. Keynes’s The General Theory describes: “…the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men … are usually the slaves of some defunct economist.”

Keynes’s A Tract on Monetary Reform – dedicated to the Governors and Court of the Bank of England in 1923 – argues for why the Treasury and the Bank of England “should adopt the stability of sterling prices as their primary objective” (p. 147).

Of course, the book simultaneously advocates the policy of flexible exchange rates: stability of sterling prices “would not prevent them aiming at exchange stability as a secondary objective.” The Fed “failing to keep dollar prices steady, sterling prices should not…plunge with them merely for the sake of maintaining a fixed parity of exchange” (p. 147).

Keynes clearly gives credit to Irving Fisher as “the pioneer of price stability as against exchange stability,” but he doubts Fisher’s policy approach based on automatic index adjustments: “If we wait until a price movement is actually afoot before applying remedial measures, we may be too late.”

Keynes quotes Hawtrey’s Monetary Reconstruction (1922) “It is not the past rise in prices but the future rise that has to be counteracted”, points to “the, often more injurious, short-period oscillations”, warns not “advisable to postpone action until it was called for by an actual movement of prices” and adapts Fisher’s approach by presenting the idea of price stability in terms of an official index number, the price of a standard composite commodity:

“It would promote confidence … (if) the authorities were to adopt this composite commodity of a standard of value in the sense that they would employ all their resources to prevent a movement of its price by more than a certain percentage in either direction away from the normal”.

Keynes favored “a general judgment of the situation based on all the available data” in the regulation of the bank steering rate over a cut-and-dry formula and in detail described what in essence comprises the economic and monetary analysis that the European Central Bank (ECB), or the Fed or the Bank of England for that matter, bases it decisions on.

“The main point is that the objective of the authorities, pursued with such means as are at their command, should be the stability of prices.” (p. 149)

Keynes was too optimistic of the power of economic ideas over vested interests: “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas”.

Nothing explains better than vested interests the 70 year chain of monetary policy disasters all over the world, up to Black Wednesday or the 13 percent drop of the GDP from 1990 to 1993 in Finland’s banking crisis.

Keynes was right in the long run. The ideas which civil servants and politicians applied to monetary management during the 1990’s were definitely not the newest in the perspective of his A Tract on Monetary Reform. But the ideas were new to many economic scribblers and still are not accepted by agitators.

Unlike Keynes’s “practical men, who believe themselves to be quite exempt from any intellectual influences”, today’s central bankers know Keynes, Irving Fisher and results of academic research. Apart from charlatans, they are nobody’s intellectual slaves, but independent thinkers and professionals of the highest caliber.

(All italics here are as in the original text!)

Green cheese factories fight excess demand for the moon – let sovereign wealth funds rescue!

2008-04-21T17:05:00.008+01:00

Keynes likened a central bank to a green cheese factory under public control. In Chapter 17, ”The essential properties of interest and money”, of the General Theory, he emphasized the combination of three characteristics of money – via their effect on the money rate of interest - to cause contraction of output and employment at the emergence of an excess demand for money.

“Through the working of the liquidity-motive, (money) rate of interest may be somewhat unresponsive to a change in the proportion which the quantity of money bears to other forms of wealth measured in money” and “money has … zero (or negligible) elasticities both of production and substitution” (p. 234).

“Unemployment develops, that is to say, because people want the moon; - men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. central bank) under public control” (p. 235).

Where does the excess demand for money stem from? In my understanding, it is the same as the source of de-leveraging.

Fifteen years ago we, in the Government Guarantee Fund established to tidy up the banking mess in Finland, fancied the US system of securitizing the loan books of the banks to transfer credit risks to the ultimate investors as insurance companies, pension schemes, mutual funds and other agents of the end savers.

But, the occurrences in the USA show that the credit risks were not totally transferred outside the financial intermediation sector, but mostly remained therein. The reason is that the risks were only wiped off the balance sheets to the SIVs (Structured Investment Vehicles). They financed the long-term loans by issuing short-term commercial paper to the ultimate investors, that is, by applying even a riskier maturity transformation strategy than the banks themselves which originate mortgages.

As the ultimate investors started to suffer losses on the mortgage-backed securities they had purchased, they grasped to be exposed to the same credit risks via commercial paper of the SIVs. To limit their losses, the investors refused to no longer buy the SIV commercial paper; they would rather hold truly liquid assets that will bear no capital loss as short-maturity treasuries. Hence an excess demand for liquid cash started, but it was endogenously magnified by another feature of the SIVs that they had credit lines from their parent banks. Who else would have re-financed the mortgages in the SIVs?

So the SIVs had to draw short-term finance from their parent banks as soon as their commercial paper market started to dry up. The same commercial and investment banks that previously parceled loans into securities are now writing down those loans, that is, the credit risks were effectively not transferred from the balance sheet of the financial intermediation sector.

Hence the US, UK and also partly Eurozone markets are in the state of an excess demand for “the moon” which cannot be choked off! The Fed, the BoE and the ECB all try “to persuade the public that green cheese is practically the same thing” by swapping government bonds for mortgage securities to kick-start bank lending, that is, by socializing the credit risks of the underlying mortgages.

“Green cheese”, unaged cheese, is near money created by the financial intermediaries.

But, aren’t these measures rather an attempt to prevent from scoring an own goal without changing the long-term strategy of monetary policy? The central banks all behave today as if the nominal quantity of liquidity were fixed as under the gold standard in Keynes’s mind and follow his advice (p. 234): “The only relief … can come from … an increase in the quantity of money, or … a rise in the value of money”, the latter meaning a decline of money rates of interest on commercial lending.

The interbank rates of the eurozone are ¾ of a percentage point higher than the steering rate of the ECB; the interbank three-month dollar rate is more than half a percentage point higher than the Fed’s steering rate and almost a full percentage point in the case of the pound sterling.

The spread of the corporate bond rates over the steering rate is almost four percentage points for the dollar, almost three percentage points for the pound while only one and a quarter percentage points for the euro. The eurozone suffers from the global banks’ access to the Euribor market via their subsidiaries therein which Sweden avoids.

Excessive rate of expansion of financial intermediaries was the true cause of the ultimate investors’ losses on mortgage securities. The US banks advanced credit to 20 percent over the value of the asset purchased, benefiting from the interbank rates of interest of one to two percent, but in the end fished too many customers who could not afford servicing their loans.

Why to venture the taxpayers’ money? Such an approach only induces the banks to walk on stilts until the next round of socializing credit risks.

Money is currently flowing to oil-producing countries at the rate which is more than enough to recapitalize all ailing US, UK and Eurosystem banks by the next Labor Day? In the end, only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.

Such a market-driven event, secretly and quickly implemented, would enable The Fed, the BoE and the ECB to score against inflation and, in a way, would represent their “hand of God” goal.

The Maradona theory of interest rate steering - will the ECB need the “hand of God” goal?

2008-04-14T13:11:00.003+01:00

EURO 2008 will be in focus in all great Asian betting countries until next July. The question is about football (soccer), not about trading currencies. But, football inspired Mervyn King, Governor of the Bank of England, to develop his Maradona theory of interest rate steering by a successful central bank; see his speech “Monetary Policy: Practice Ahead of Theory”, 17 May 2005
http://www.bankofengland.co.uk/publications/speeches/speaker.htm#king

The Maradona theory deals with the power of expectations about the future conduct of monetary policy affecting the choices of households and firms today.

In the 1986 World Cup in Mexico City, Diego Maradona scored against England after a 60 meter run in a straight line while beating five English players. This spectacular straight-on performance was possible because the defenders reacted to what they expected Maradona to do, to move either left or right.

Monetary policy can work similarly, Governor King described. Market interest rates react to what the central banks are expected to do. When the households and firms expect the official interest rates to move either up or down, those expectations are sometimes sufficient to stabilize private spending while the steering rates in fact move very little.

Hence the action is in the forward rates, in the expected future short rates of interest. They effectuate the outcome. The experience of the Bank of England in 2002 perfectly supports the Maradona theory. Even thereafter the official bank rate has shown considerable stability in contrast to previous decades.

Neither is the behavior of the Eurosystem interest rates against the Maradona theory. The steering rate of the ECB has moved within two percentage points since September 2001 and stayed at 2.00 percent from June 2003 to December 2005.

The Governing Council of the ECB has kept its steering rate on hold since June 2007. Will it score as Maradona to deliver price stability without raising the steering rate?

Prior to last Thursday’s meeting of the Governing Council, financial markets expected two rate cuts of 25 basis points from the ECB by the end of this year, but no longer so after the meeting.

Other powerful forces help the ECB. Strong euro re-diverts world spending from goods and services produced in the euro area toward production outside. Housing markets have cooled in parts of the euro area.

Funding from equity issues is more expensive because of the drop of equity prices: to a raise a given euro amount for investment finance, the companies must hand on a bigger slice of the future dividends to the subscribers of new issue than before the drop of equity prices. High-yield corporate bond issues must similarly promise a higher yield after the re-pricing of their risks. In principle, these make investment finance more expensive.

But, bank borrowing by the non-financial companies is growing briskly, by almost 15 percent annually in February, which may be due to the companies substituting market funding for bank borrowing. It is a sign that investment spending will not be cooling soon. Projects take a long time to complete.

Anyhow, the ECB faces a dilemma in its primary objective, price stability. It may need Maradona’s first goal in the above match. It was the “hand of God” goal that Mr. King described as “an exercise of the old ‘mystery and mystique’ approach to central banking,” acting unexpectedly, time-inconsistently and against the conceived rules.

Such a behavior by the ECB may well be the action which is best consistent with its overall strategy of meeting the inflation target.

The ECB dozed off!

2008-04-11T07:39:00.003+01:00

In Britain the target rate of inflation is set by the Chancellor of the Exchequer (Minister of Finance). Whenever the actual inflation rate surpasses the target by more than one percentage point the Governor of the Bank of England, on behalf of its Monetary Policy Committee (MPC), must send the Chancellor an open letter, explaining
1. the reasons why inflation has risen above the target,
2. policy action that the MPC proposes to deal with it,
3. the period within which the MPC expects inflation to return to the target, and
4. how the approach chosen by the MPC meets the UK Government’s monetary policy objectives.
These points appear in the introduction of the Governor’s letter of 17 April 2007 to the Chancellor.

The actual inflation in the Euro area exceeded its target – to keep inflation below 2 percent - by more than one percentage point last November. The introductory statement by Jean-Claude Trichet, President of the ECB, before yesterday’s press conference gave many reasons why the Euro area inflation has risen above the target and will stay above it for “a rather protracted period” which Mr. Trichet spelled out to 18 months in his answer to a journalist’s question.

But, all those reasons are outside reasons, as if they were beyond the control of the Governing Council of the ECB. They are not. There is no explicit mention that the inflation rate doubled in the Euro area since last August because of its lax monetary policy that shadowed the Fed’s decisions.

We not only read in the statement about “continuing very vigorous money and credit growth”, without implication in the doubling of the ECB’s favorite measure of inflation, but also “We (the Council) believe that the current monetary policy stance will contribute to achieving our objective” of maintaining price stability in the medium term.

Only a belief is offered to us, but nothing in explanation of policy conduct; as Pandora’s box, all evil spirits have escaped, only Hope remains!

The decision making bodies of the ECB will reach a middle-school girl’s age next June. It is time to publish the reasoning and argumentation behind the decisions of the Governing Council, the minutes of its meetings. Also, greater transparency necessitates a similar institutional arrangement as the Governor’s letter to the Chancellor in Britain.

Two years ago the ECB was “vigilant”, sometimes even “extremely vigilant”, no longer. Yesterday Mr. Trichet mentioned twice that the Council is “alert”.

Transparency does require mentioning when the Governing Council dozes off!

Will the ECB deliver price stability?

2008-04-08T16:29:00.005+01:00

The Governing Council of the European Central Bank ECB need to raise its steering rate, but to cut the rate of its lending facility. The council will meet on Thursday, 10 April 2008.

The ECB is on the verge of losing its credibility in delivering price stability in the medium term. The annual rate of increase of the harmonised index of consumer prices HICP in the Euro area has hovered above 3 percent since last November. The recent preliminary estimate for March 2008 is even 3.5 percent, double the rate in last August.

The actual consumer price index CPI, including energy and food, has risen even faster than HICP, but the latter is catching up the headline rate of the CPI. This must mean that the expected rate of inflation ERI is converging to the realized rate of the HICP and CPI.

The task of all central banks is nowadays regarded as managing inflation expectations. When the ERI exceeds the realized rate of the HICP inflation, the latter is accelerating. When the ERI falls short of the realized HICP rate, the latter is decelerating. In equilibrium, the expected and realized rates are equal.

But, the ECB aims at delivering price stability, maintaining the realized rate of the HICP inflation close to, but below 2 percent. Because the realized rate has doubled since last August, the unobservable ERI must have flown well above the ECB target long before that, perhaps since the beginning of 2006.

Christian Noyer, Governor of the Bank of France, said in Prague last week: “A solid anchoring of inflation expectations remains a pre-requisite for rate cuts in times of heightened financial uncertainty and downside risks to growth.''

But, will the ECB need a cut of its steering rate? Its President Jean-Claude Trichet clearly emphasized in the hearing at the European Parliament 26 March 2008 that “In the view of the Governing Council, risks to the medium-term outlook for inflation are on the upside,” citing a number of factors from “further rises in oil and agricultural prices” to “administered prices and indirect taxes.”

This assessment hardly prepares financial markets for anchoring inflation expectations to the ECB target rate of inflation in the medium term or, for a rate cut.

To manage inflation expectations, the ECB need to raise its steering rate, the minimum bid rate of the refinancing operations, to 4.25 percent.

And, the management of the fragile financial system needs a rate cut of the ECB lending facility to 4.75 percent which is the current level of the 3 – 12 month Euribor interest rates.

Comeback of corporation tax! Goodbye banking crisis!

2008-04-04T16:29:00.003+01:00

The economics profession long ago doomed source-based taxes on real capital to a race to the bottom because of increased mobility of resources, capital in particular. Corporation tax is the major source-based tax on capital, having visible tax competition as regards the statutory rate.

Viewed from Finland, the reality shows quite an opposite development. Tax revenue from corporation tax has tripled over the past two decades!

Corporation tax typically raised revenue from 1% to 1.5 % of the GDP in the 1980’s but 3.7 % in 2006 while the statutory rate on corporations was simultaneously slashed from 60 per cent to 26 percent.

Hence the growth of tax revenue resulted from the broadening of the tax base. The companies are no longer forced to invest in machinery and structures to gain abundant tax depreciation charges for the purpose of hiding their taxable profits as in the 1980’s.

Instead of thinking the short-term tax savings brought about by business investments, the corporations think nowadays about their true long-term profitability. Hence the tax system of the 1980’s induced businesses to wasteful, inefficient real investments while the current tax system promotes efficient allocation of investment and capital.

How come did the politicians of Finland have such a foresight as regards the growth of tax revenue when they chose for a lower rate of corporate tax applied to a broader base of taxable income? They didn’t. The reason was the banking crisis in the beginning of the 1990’s.

Lax monetary policy from the mid 1980’s in the western world meant that international financiers flushed Finland with foreign money because the poor Bank of Finland did not understand how to control the growth of money and credit stocks in financial markets. The bank was accustomed to only give prescripts.

The Finnish bankers had previously rationed loans, granted them to their favored customers. At the end of the 1980’s bankers regarded themselves as businessmen. Their remuneration depended on the growth of loans granted.

And, everyone in Finland tried to hedge against galloping inflation by investing in real estate in particular. The other bugbear to hedge against was the taxman, but it offered ideal fiscal incentives for investments – accelerated tax depreciations combined with a high statutory tax rate.

The result was reckless bank lending and a classical banking crisis. One means to end it was to restore profitability of the enterprise sector and solvency of the bank customers. That is why the politicians parted from their old dirigible fiscal tools.

Connecting with the current calamity in financial markets, we have seen international investors financing the growth of consumption and investment in the USA and learnt from asymmetric incentives in its mortgage origination and repackaging businesses.

The only material difference from the crisis of Finland is that the US foreign debt is denominated in its own currency. Therefore the consequences on real economy from the debt crisis will not be so severe and long lasting in the USA as was the case with banking crises of both Sweden and Finland.

Trough of the US debt crisis?

2008-03-31T11:19:00.005+01:00

Financial commentators show some optimism that asset bubbles would be by-gone. The latest, the bursting of the house prices, may only just be spreading to Europe – Spain and the UK in the forefront, not to forget Estonia in the fringe.

The decline of the high yielding corporate bond prices since their July 2007 high – what was 120 then is 100 today –seems not to entitle to a bubble burst, presumably because their total market is small in respect of the residential mortgages.

But, problems in the latter are spreading into commercial. Prices are also down in commercial properties in which my source of intelligence is David E. Witt, Witt Ventures LLC in Atlanta, Georgia. He has 38 years’ experience in real estate development and investment and saw the 1974 - 1975 melt down of commercial property prices.

“The commercial debt market has come almost to a standstill with the exception of 60 percent to 65 percent loan-to-value mortgages. “ As a wider consequence of the collapse of Bear Stearns, he adds: “no lenders are writing CMBS (commercial mortgage backed securities) debt anymore. That particular market is totally dead.”

Problems in commercial mortgage markets will endogenously feedback the downturn in the residential markets, intensifying the process of debt deflation as shortly described in my previous blog.

But, there still remains the biggest bubble of all, the huge market of the U.S. treasuries, to be punctured. The prices of Treasury notes and bonds have elevated to that infamous level of irrational exuberance. Last Friday’s yields varied from 1.6 percent on the maturity of 2 years to 2.5 percent on the 5 year’s maturity which are well below any estimate of the trend growth rate of the US economy plus the Fed’s implicit medium term inflation target.

After last week’s blunt cut of the steering rate, the Fed’s most important task is to get the inflation expectations quickly anchored so that they will not threaten its goal of price stability in the medium term, by preventing inflation expectations from feeding into the second-round effects in price and wage setting.

The yields on the U.S. Treasuries are bound to rise and their market prices to decline irrespective of whether the steering rate will descend or ascend and whether the Fed succeeds or fails in delivering price stability.

It means massive losses to the investors in the most volatile medium term maturities, in particular. The trough of the debt crisis is yet to be seen.

The financial system is able to cover its losses only from the cash flows of its basic business. Hence over a longer period of time considerably higher risk premiums and higher interest rates on all private sector loans will be needed than experienced during the run up to the liquidity bubble.

Therefore the U.S. economy will recover slowly from its current mayhem – and Europe will pay its share of the costs of the almost global mispricing of risks.

The Fed’s bubble policy

2008-03-25T17:24:00.007Z

The record of the Greenspan era’s Fed in conducting monetary policy repeated a simple behavioral formula: a crisis to which the Fed reacted by swiftly and aggressively cutting its steering rate of interest that quickly increased liquidity in the financial system; in between the crises Wall Street was given a loose rein to trot.

Ben Bernanke’s Fed is a similar addict. Why?

Over two decades the whole world experienced an exceptionally loose monetary policy that kept both nominal and real rates of interest historically low in the developed countries. Central banks allowed the stocks of money and credit to grow too fast for too long that induced the agents to chase returns everywhere and in any possible asset, dismissive from the risks involved. That pumped the prices of equities, bonds and houses up. The whole world lived in an enormous liquidity bubble in which the pricing of risks was distorted.

The disequilibrium created two forces that are in effect during the process of adjustment that started about a year ago.

The prices of goods and services are closing “normal” their gap to asset prices that sped up the rate of inflation.

An increased appreciation of investment risks brought about a decline of private sector asset values and, in particular, the market prices of the assets that represent claims to the original assets. It causes debt deflation that will freeze up the whole financial system.

Such a destructive spiral was experienced in Finland during the years of 1991-1993. The agents’ attempts to pay off their debts were eroded by declining asset values, creating negative equity. That decreased spending and production, causing massive credit losses in the banking sector, after the collapse of the fixed exchange rate regime in particular. The bail out of the banks, their depositors and international financiers cost 8 per cent of the year 1990 GDP to the taxpayers. In addition, the banks themselves digested credit losses equivalent to over 6 per cent of the 1990 GDP.

The Fed regards the force of debt deflation as a much greater peril than the threat of quickening inflation. That is why it chose to lean on the proven drug, in a way, giving support to the top level players of the financial system.

Does an alternative medication exist? Perhaps not, after the crisis erupts.

But, before the event there are many preventive cures from an explicit inflation target in the medium term to classical surveillance of money and credit stocks. Will the Fed be the first to also weigh asset prices in its inflation target?

Some observers always recommend tighter regulation of the financial system. John Maynard Keynes - in the final chapter of his 1939 edition of The General Theory of Employment, Interest and Money – conceived “a somewhat comprehensive socialisation of investment” and the State being able to determine “the basic rate of reward to those who own” investment resources. And, he believed in “a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”!!!

Regulation and non-neutral taxation of the final savers (owners) are the engines of financial innovation because they induce regulatory arbitrage and tax arbitrage. By combining those with lax monetary policy, the process to the present calamity in the financial system is to be understood.