Martin Wolf jettisons EMH

In his latest column, Martin Wolf reviews Andrew Smithers’ latest book and uses the opportunity to jettison the Efficient Markets Hypothesis.

The efficient market hypothesis, which has had a dominant role in financial economics, proposes that all relevant information is in the price. Prices will then move only in response to news. The movement of the market will be a “random walk”. Mr Smithers shows that this conclusion is empirically false: stock markets exhibit “negative serial correlation”. More simply, real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. The right time to buy is not when markets have done well, but when they have done badly. “Markets rotate around fair value.” There is, Mr Smithers also shows, reason to believe this is true of other markets in real assets – including housing. [More here]

Perhaps, Bibek Debroy should take a look at the book and these comments by Martin Wolf:

The era when central banks could target inflation and assume that what was happening in asset and credit markets was no concern of theirs is over. Not only can asset prices be valued; they have to be. “Leaning against the wind” requires judgment and will always prove controversial. Monetary and credit policies will also lose their simplicity. But it is better to be roughly right than precisely wrong. Pure inflation targeting and a belief in efficient markets proved wrong. These beliefs must be abandoned. [More here]

John Reed writes in

Volcker’s Advice

To the Editor:

Re “Volcker’s Voice, Often Heeded, Fails to Sell a Bank Strategy” (front page, Oct. 21):

As another older banker and one who has experienced both the pre- and post-Glass-Steagall world, I would agree with Paul A. Volcker (and also Mervyn King, governor of the Bank of England) that some kind of separation between institutions that deal primarily in the capital markets and those involved in more traditional deposit-taking and working-capital finance makes sense.

This, in conjunction with more demanding capital requirements, would go a long way toward building a more robust financial sector.

John S. Reed
New York, Oct. 21, 2009

(Taken from here. The original is here)

I think that says it all.

India’s fiscal and monetary policy – studies in contrast

Business Standard writes a good editorial on the need for fiscal deficit consolidation in India. It is a timely reminder:

The deterioration in fiscal parameters in 2008-09 and 2009-10 has been on account of both the fiscal stimulus and pre-election populism…..If during the downturn monetary policy had to accommodate the needs of fiscal policy, in months to come, fiscal policy must step in and free monetary policy of some of the burden. This means reducing revenue and fiscal deficits, improved expenditure management and revenue mobilisation. [More here]

How do you rate the chances of this happening? Well, I do not rate it very high.

That said, India’s monetary policy continues to shine like a beacon of hope. It is a breath of fresh air in terms of policy competence. When others are talking of exiting easy monetary policy, the Reserve Bank of India has gone ahead and done it. The press release that announced the monetary policy decisions taken today is clear and crisp. Kudos to RBI. This press statement should mollify or even dismiss the critics who questioned RBI’s communication strategy and style some time ago.

Now, if only there is some governance and fiscal prudence, India’s flag would be flying rather high. That it is not explains why the world is still so much in thrall of China, no matter how unjustified it is.

Dr. Y. V. Reddy on India’s financial system – 2/2

Seventh question: Is there any evidence of irresponsible lending, like the sub prime in U.S.A.?

There is no direct evidence of any large scale lending in India that could be characterized as irresponsible lending. But, a study should be made of commercial banks’ lending and support to micro-finance institutions, which are profit-seeking (MFI-PS). Here also, one can describe a possible scenario. A commercial bank may legitimately prefer to lend to an MFI-PS at a rate far higher than it is permitted to lend to its low-income customers. Bank lending to MFI-PS gets the benefit of treatment as priority sector lending. The MFI-PS in turn charges market-based rates of interest, while not attracting the jurisdiction of laws relating to money lending or usury. Micro-finance is an area of respectability, and impressive profitability of MFI-PS in India is attracting investments from private equity funds globally, with a huge premium. [More here]

There may therefore be merit in a detailed analysis in a sort of supervisory review of the incipient tendency towards irresponsible or usurious lending through MFI-PS: It is useful to note that these MFI-PS are growing too rapidly and making too much profits for comfort.

Some insiders in the Microfinance sector bristle at this suggestion, first made in a Wall Street Journal article. There is an interesting discussion of that article here and a counter-response from SKS founder Vikram Akula is here. Vikram Akula responds with some specifics. He cites reports filed by MFIs to MIX – the non-profit Microfinance exchange and he cites other studies that refute the largely anecdotal WSJ story. Unitus’ response to the WSJ article is lacking in specifics. Ujjivan’s response is here too.

My suggestion to these industry insiders is that while their exasperation may be understandable, it may not still necessarily be correct.

One should welcome such studies – no matter how sloppily researched they might be (in their eyes) – as important ‘checks and balances’ on their march to create bigger and more sustainable financial inclusion.

After all, one did not have to have the majority of sub-prime loans go delinquent for it to have systemic impact. Securitization and higher leverage played their part too, no doubt. In fact, the level of scrutiny on MFIs – the loan originators – should rise substantially once securitization of microfinance loans picks up.

It is good to have some one warn about the possibility of risks as long as it remains a possibility and not a reality.

In this context ,the reports of a critic on KIVA and the response of the KIVA are both refreshing.

Dr. Y. V. Reddy on India’s financial system – 1/2

The Business Standard has published the full text of the speech that Dr. Y. V. Reddy had delivered recently at the S. Guhan Memorial Lecture in Chennai on October 22nd. The full text can be accessed here and a summary article based on that speech, can be accessed here.

Some remarks stand out:

Is (India’s) macro economic management reasonably balanced?

The answer is obviously yes – by and large. We have no excessive current account surplus or deficit; no excessive dependence on exports or external demand; no excessive reliance on investment or consumption expenditure; and, no excessive leverage in most households or corporates or financial intermediaries.

We are, however, vulnerable to shocks on four fronts: Fuel; Food; Fiscal; and Finance – external. In regard to fiscal, the quality of management and subordination of monetary policy continue to be issues. On external sector, the quality of capital flows will continue to be an area of concern. In particular, quality of FDI (Foreign Direct Investment) also deserves a close look, in terms of extent to which FDIs are financing green field projects.

It would be interesting to find out what he means by quality of FDI deserving of a closer look. When I looked at the BoP statistics that RBI released for the first quarter of the current fiscal year, 2009-10, I thought the macro-trends were all healthy. Sustained and increased FDI flows, lower share for portfolio flows in the overall capital inflows, etc.

In fact, on September 30th, the Reserve Bank of India released three reports. The other interesting one is on the sources of variation in India’s foreign exchange reserves. In the first quarter of the fiscal year 2009-10, India’s FX reserves went up by the equivalent of USD13.16 billions. Out of that, USD13.04 billions came from valuation changes (99.1%). Kudos to RBI. Indian FX reserves are fully diversified, away from U.S. dollars. That is why, 99.1% of the changes in reserves came mainly from improvement in the value of reserves India held, when expressed in U.S. dollars. In the second quarter, U.S. dollar weakened. The value of India’s reserves went up. The message is clear.

When it comes to excessive ‘financialisation’, Dr. Reddy does not worry about the usual suspects in India. In fact, he thinks that it might be happening in the way infrastructure is financed in India. That shows an open mind.

I will deal with his comment on micro-finance in the second part of this post.

Is China helping or hurting the U.S.?

One of my friends forwarded me this blog post by Paul Krugman and asked me what Paul meant by ‘that right now the United States has nothing to fear from Chinese threats to diversify out of the dollar’.

What he means is this:

If China sells dollars and puts the proceeds into other currencies, it helps the U.S. (dollar weakens and other currencies appreciate). That is, given the weak state of its domestic economy, US would like a weak dollar to export its way out of trouble. Hence, that is what the Fed would like to do but is not doing (shall we say, out of fear of provoking a diplomatic storm with the Europeans?)

But, unfortunately, China is not doing that. It is buying dollars because it does not want its currency to appreciate against the U.S dollar. So, it is not helping America. It is hurting America because it is undermining America’s intention and inclination to see the dollar weaken, esp. against Asian currencies.

This is not a new argument. He is putting it in different words.

The only problem with his thesis above is that he thinks that the U.S. would really like China to sell dollars. That may not be always true. The U.S. has conflicting objectives.

For economic reasons, it wants a weaker dollar and, yet, at the same time, it wants some one to buy all the Treasury debt, it is issuing. Both cannot happen at the same time. They are conflicting goals.

These conflicting goals are further compounded by another conflicting goal that the U.S. has which is to maintain the international status of the U.S. dollar.  In some sense, China buying dollars or Treasury bills helps the last goal and the goal of finding a buyer for its Treasury debt issuance. So, that is 2 out of 3 arguments that actually suggest that China is helping America by keeping dollar stable, even if it hurts economically in the short-run.

Therefore, what does the U.S really have to complain on China’s behaviour? Not much

Complaints must come from other Asian nations, incl. Japan and from the EU. They are either supplicants or too timid or both.

Paul Krugman makes this point more bluntly in his column on October 23rd:

The biggest victims, by the way, are probably workers in other poor countries. In normal times, I’d be among the first to reject claims that China is stealing other peoples’ jobs, but right now it’s the simple truth. [More here]

So, what is the way out?

A nasty spell of inflation in China would force them to rethink on what they are doing. They may stop intervening to keep their currency stable/cause it to weaken. Would that help the US? Perhaps not in the immediate run (if my above arguments are correct) but in the long-run, it helps the world.

So, far better for the U.S not to put pressure on China to go one way or the other, for it is unclear if the U.S benefits or not – given its economic malaise  – when China stops intervening in the foreign exchange market and stops accumulating FX Reserves.

Bibek Debroy on (Indian?) bubbles

It is a strange piece by Bibek Debroy in Indian Express. He rails against government controls in the end. Not many would quarrel with that. But, what does government control has to do with asset price bubbles. It is in the domain of monetary policy makers. To say that it is hard to spot bubbles beforehand is a stale and wrong argument. Monetary policy often involves judgement under uncertainty as does most decisions in life and business. Central banks have many indicators to spot trouble brewing. To deny a bubble under the pretext that intrinsic value is hard to define, is to go over territory that has been well trodden.

What has the Federal Reserve achieved by ignoring asset price bubble in the Technology sector first in 1999-2000 and the the housing bubble? The unemployment rate, officially, is 17.0% (U6 measure) and unofficially, a lot more.

Monetary policy cannot clean but can lean. The one sentence that Bibek Debroy cites from the letter written to the Queen by some British economists rings so true:

It was a cycle fuelled, in significant measure, not by virtue but by delusion

Perhaps, Mr. Debroy wants to pre-empt any central bank tightening in India which he views as premature. Perhaps, he is right on that one. After all, credit growth in India is still anaemic and that is usually one warning sign of nascent bubbles. Given that it is not even flashing amber yet, the RBI could take some risk with leaving policy as it is, for now.

But, that is no excuse to dismiss the whole of idea of addressing bubbles pre-emptively.

Banking pyramid

‘Economist’ (Oct. 22, 2009 issue) ends a piece on American banks with this pithy observation on the state of the health of the American banking system:

Right now America’s banking system resembles a pyramid. At the top, two or three firms are doing well. But beneath them are a handful of giant conglomerates that are struggling towards profits, a tier of middling banks with overexposure to risky assets, and a vast base of small banks in deep, deep trouble. [More here]

Wonders if it captures the stratification of the American society itself, these days?

In good company

Gilian Tett in FT:

In the meantime, it is crystal clear that the longer that money remains ultra cheap, the more traders will have an incentive to gamble (particularly if they privately suspect that today’s boom will be short-lived and want to score big over the next year). Somehow all this feels horribly familiar; I just hope that my sense of foreboding turns out to be wrong. [More here]


Macro Man can’t shake the feeling that we’re all repeating the mistakes of the last cycle (in fast forward, no less!) and that when the reckoning comes, it won’t be much fun. [More here]

Emanuel Derman:

My instinct much of the time these days is that the cure the government has chosen for the excesses of the past decades is the same sickness that caused it. Each successively larger mini-crisis since the mid-90s was met by an attempt to restore the status ante quo which temporarily postponed a still larger crisis that then led to a still larger intervention which led to … …

I don’t totally believe the world would have ended if various firms had fallen into the hands of bondholders, and I like to think that if it had, then we’ve only postponed it. [More here]

I might have been wrong with my warnings in the last few months but I think  I am in good company. That is non-trivial consolation.

On bankers and banks

Via BaselineScenario, I landed on this article by Joe Nocera. It needs no explanation. It lambasts the American Bankers’ Association for lobbying against the Consumer Protection Bill that has been watered down by Mr. Barney Frank already. It is self-explanatory.  I do not want to spoil your fun by citing selectively. Read the whole stuff, yourself.

Then, there was this typical hardhitting speech by Merwyn King at Edinburgh on the banks, similar to his Chatam House speech in June. TGS had blogged it here and wrote about it in MINT here.

Excerpts from the most recent speech:

If our response to the crisis focuses only on the symptoms rather than the underlying causes of the crisis, then we shall bequeath to future generations a serious risk of another crisis even worse than the one we have experienced.

To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.

The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history.

It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place. The sheer creative imagination of the financial sector to think up new ways of taking risk will in the end, I believe, force us to confront the “too important to fail” question. The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.

Although there are no simple answers, it is in our collective interest to reduce the dependence of so many households and businesses on so few institutions that engage in so many risky activities. The case for a serious review of how the banking industry is structured and regulated is strong.

If unsustainable capital flows provided the fuel and an inadequately designed regulatory system ignited the fuel, the past two years have shown how dangerous it is to let bankers play with fire.

When I read that Darling and Brown have hit back at King, I sensed that he had said something right.

Of course, my good friend Jim Walker, in a note to his clients, called King (not personally but as a central banker) a hypocrite. Strong words. I do not know or cannot recall whether King belonged to the ‘can clean but cannot lean’ school. Nor am I as ready as he is, to absolve the industry of its collective responsibilities – capitalism without morality ≠ free markets or competitive markets.

Yes, central banks (more particularly, the Federal Reserve under Chairman Greenspan of which Mr. Bernanke was a member) have a very large share of the blame. But, not the whole share.

I would argue that other central banks had to ‘dumb down’ to low interest rates thanks to Fed’s ultra-low interest rates. Otherwise, in a world of capital mobility, currencies rise to unsustainable levels and further hollow out manufacturing and physical share of GDP that is already hollowed out by globalisation and offshoring. That would only have hastened the arrival of the exaggerated importance of finance in national output. So, blaming King is harder than my friend Jim Walker makes it appear.

One Tim Exall writing for the FT seems to echo my friend Jim Walker, however:

Perhaps, however, there is an even more fundamental problem to address and, if so, Mr. King himself would clearly be one of the principal suspects… What has the recent move towards zero rates done, for example? It has encouraged more asset bubbles and excessive risk-taking, and punished savers – and this at a time when we are told we must save more.

This column by Martin Wolf started well. Precise, well written and concrete. Towards the end, he leaves things open-ended and inconclusive by reiterating the issues that are open. I say, why not cap salaries/compensation?

If I take risk and get rewarded for it and if I fail, you take the loss, don’t you have the right to restrict how much I make out of the risks I take (do I really take the risk, in the first place, if the loss is yours?)?

In fact, I should make zilch, nada, nothing, given the asymmetric pay-off.  So, merely restricting pay seems like a slap on the wrist.

Further, if it discourages ‘talent’ from joining banks, so what? Whom did this talent benefit? For whom is this talent needed? Public interest? It paid itself and the executives hired them paid themselves when the talent made short-term profits at the cost of future losses to be borne by tax-payers. Perhaps, the talent is better used elsewhere in the society. It might be a blessing in disguise for the economy, for the society.

Read what Emanuel Derman has to say on the issue of banks’ profits:

Usually when someone buys an out-of-the-money put and can’t pay cash, they have to fund it with an out-of-the-money call, the two options together comprising a costless collar. So, the banks that got saved by the taxpayers should, in all fairness, be short a call to the taxpayers, and their profit and upside above some reasonable level should belong to taxpayers now that the call is in the money.