Captured and jailed for ever

The objections of the French Central Bank governor Christian Noyer to the European Financial Transactions Tax is shocking, sad and comical – all at once. France is better off seeking competitive gains elsewhere and not in and through Finance.

Howard Davies, first and former Chairman of the UK Financial Services Authority (FSA) notes in a piece for ‘Project Syndicate’ that

too big to fail” is another area in which the initial post-crisis enthusiasm for global solutions has failed. The unfortunate result is an uneven playing field, with incentives for banks to relocate operations, whether geographically or in terms of legal entities. That is not the outcome that the G-20 – or anyone else – sought back in 2009. [Link]

Good heart no more?

I had modified Charles Goodhart’s name in the blog post subject header. I could not understand his defence of ‘Help to buy’ policy of the UK. He says it would trigger a supply response. Now, that can be said of any measure that boosts demand. Supply will respond, if profitable enough. The question is whether the economy is better off directing resources to housing or something else? How about tweaking the zoning restrictions and see if demand and supply find their own equilibrium instead of government stoking housing demand.

5% owner’s equity means LTV of 95% regardless of whether it comes from the government or the bank. I cannot understand why they harp on the bank’s LTV ratio being below 90. With London home prices about 7 times that of the rest of England, cannot see much value in keeping LTV north of 60% for London.

The final thing that beats me is when they say that this policy will help the government keep track of the housing bubble? Is the demand for housing going to come only from this policy? In fact, the whole point of the criticism is that this policy is not needed at all when London home prices have barely moved after the crisis of 2008 compared to markets elsewhere. The nominal interest rate is at 0.5% and real rates are massively negative already. So, housing did not need a government helping hand and demand exists outside of the ‘Help to Buy’ scheme. How can government keep track of it?

If a government wants to keep track of the housing bubble, is this the most efficient way of going about it? Real estate transactions, housing loans and home price data would suffice.

If this logic were true, can we extend the logic to monitoring stock market bubbles? The government can start a scheme to lend money people to buy shares and thus it can monitor if a bubble is being formed in the stock market.

Strange. Very strange.


There have been some interesting and rather useful exchanges on this blog on the issue of the survival of the single currency in Europe. Well, with EURUSD on its way to 1.40, we do not know if the survival question is better posed to Americans on their currency. Of course, a strong Euro may be a problem for the Eurozone. But, then, there are lags and lags and we do not know when and if there would be a day of reckoning for the Eurozone or the single currency. In any case, that is what we discussed in this post. Thoughts stirred by the comments by Anindya Mitra also led to this sequel article by Yours Truly in MINT.

While searching for articles by Luigi Zingales in, I came across a very thoughtful piece by Michael Bordo and Harold James on the Eurozone. The piece is titled, ‘The European Crisis in the context of historical trilemmas’ and it makes several interesting observations:

(1) The classic trilemma of monetary policy – fixed exchange rates, free capital flows and independent monetary policy – is extended into other areas with ‘independent monetary policy’ replaced by ‘financial stability’, ‘national policy indepenence’ and ‘democratisation’.

(2) The Eurozone worked quite well as a disciplining mechanism before it entered into effect, but much less well afterwards.

(3) When the democratic/popular backlash occurs, it takes the form of rejection of international/cross-border political commitment mechanism. Voters are surprisingly discerning. Opinion poll data shows a major increase in hostility to the EU in peripheral countries, but with no corresponding unpopularity of the common currency. Hostility to the EU is also evident in parliamentary elections results in Greece and Italy.

(4) The trilemmas are worse in the recent context because of the absence of an escape clause. In the absence of an exchange-rate option, there is a need for greater debt reduction, but that raises a politically awkward question of the distribution of losses between the private and the public sector.

This short paper by Michael Bordo and Harold James is worth reading and reflecting upon.

China Rating and Rebalancing

On the day FitchRatings (majority French owned) downgraded the outlook on US rating, it had also released a statement on China’s single A rating and how it was contingent on rebalancing occurring. There was also a small research note attached to that press release. Both were useful. The media ignored that, (un)surprisingly.

In fact, the sense one got that if the US AAA rating was undeserved (“The U.S. is the most heavily indebted ‘AAA’ rated sovereign, with a gross debt ratio equivalent to double that of the ‘AAA’ median.”- Fitchratings), then China’s single A rating too was rather undeserved and based on the arguments that Fitch had put out and on the basis of the evidence of the last two months (credit spigots opened up), there were both necessary and sufficient grounds to downgrade China or at least put its rating on a negative outlook already.

You can find Fitch press release here. It contains the link to the underlying report that has the analysis.

Inefficient selection

Mr. Luis Miranda pays a tribute to Eugene Fama in an op.ed for MINT. In his natural desire to sign the praises of the winner of the ‘Bank of Sweden’ prize for economics in 2013, he eschews conceptual rigour.

A market crash does repudiate efficient markets theory because, among other things, efficient markets postulate that financial markets (and hence asset prices) discount all relevant (publicly available) information instantaneously.

A crash is a ‘catch-up’ on the part of the market with information unless that information was really ‘news’ to the market.  Therefore, a crash reveals that financial markets (and investors) have not been linearly and continuously discounting relevant information. In other words, asset prices had decoupled from information. That is what a crash proves. Hence, one of the tenets of market efficiency is disproved by market crashes.

The presence of active fund managers,the search for and the willingness to pay for alpha repudiate conclusively market efficiency theory.

Like all theories in social sciences, it was at best a point of departure to analyse the real world. At worst, it was a comprehensive misrepresentation of reality. 

In recent years, Prof. Fama has rallied behind the calls (by Prof. Anat Admati) for banks to beef up their equity capital. He has signed at least one open letter to regulators to dismiss bank claims against having higher equity capital. So, I am prepared to ‘overlook’ his work on financial market efficiency. 

(p.s: Did not know until I went through this interview of Robert Shiller with the Washington Post newspaper that Janet Yellen and Prof. George Akerlof were couples. John Kay seems to mirror my thoughts on the bizarre logic behind the Nobel Committee’s selection of economists and their underlying philosophies).

Bubble vs. Bust

Well, the header of this particular blog post is misleading. The UK did not really have a housing bust. Yet, the Conservative government has come up with a housing bubble to boost economic activity. It is underwriting mortgages and is stumping up cash. Several articles have appeared recently against this. I present you links to them. Some of them may be behind a subscription firewall.

For a good understanding of the UK housing market, read the Martin Wolf article.

The head of Lloyd’s Bank has issued a warning. Coming from an industry member, it is tempered. But, the mere fact that an industry head felt compelled to voice it indicates the enormity of the risks that this scheme carries.

The best of the lot is the article by a FT journalist who moved back to London recently and is planning to move out again, because of the absurd levels of neurotic activity in London.

The UK credit boom – in less than five years after the previous credit boom and bust – is not just confined to the housing market.  UK consumers have taken to credit in a big way (again) to finance new car purchases. Car makers have turned to the UK because of sluggish conditions in continental Europe.

One of the underlying assumptions of the Chicago School of market economics (and, by extension, financial market efficiency) is the rational economic agent who weighs up all benefits and costs and discounts them correctly with an appropriate risk-adjusted discounted rate and uses sufficiently long horizons to estimate benefits and costs of his/her actions (or inaction). Such rational economic agents are supposed to counteract stupid and short-term policy decisions of governments. QED.


US debt crisis

I had not posted anything on this matter because there is far too much out there already. Newt Gingrich wrote something interesting in FT. Basically, he argued that why the Presidential elections of 2012 did not settle the debate on Obamacare. Some readers have exposed the fallacy of his claims on this matter, however. Clearly, I am no expert on Obamacare and its pros and cons. Hence, I am not going into it.

Societies cannot and should not abandon their less privileged to market forces completely. Yes, there is a need for carrots and sticks for individuals to take responsibility for their actions and consequences. But, as with most things in public policy, it is an art and not science and certainly there is no one size that would fit all.  It is about experimentation and being open to new ideas and facts as they emerge.

In any case, if Republicans are really serious about balancing America’s books (American deficits had actually exploded only under Republican Presidents), there are several other areas to focus on first.

My ‘superficial’ view is that, in the light of the massive build-up in measures of inequality in the US, it is both unwise and socially dangerous and divisive to focus on social welfare programmes as the areas of scrutiny in budget expenditure.

Regardless of how and when the debt ceiling issue is settled and the US government shutdown is lifted, this episode cannot have enhanced the image of America in any way. That point is well brought out by three FT journalists – Gideon Rachman, Edward Luce and Richard McGregor.

A word of caution: these three articles might be behind subscription firewalls.

Free non-sense – 2/2

Continuing from where we left off in the earlier post, we reiterate that for stimulus seekers no stimulus is enough and no stimulus is too much.

I chanced upon this blog post (my misfortune) by ‘Free Exchange’ this morning. Apparently, this is in response to a response to his blog post. Without reading his original and the response by another, we can make sense (?!) of the issues by reading this one long post of his.

We shall state his assertions followed by our responses:

Assertion 1: It is fair to note that low interest rates, particularly low long-term interest rates, can encourage financial behaviour that might in some circumstances increase vulnerability to crisis. But long-term interest rates are determined by many different factors, including the outlook for real growth and inflation expectations.

Response 1:Excessively below normal long rates do not lead to real investment but to speculative investments. The U.S. economic expansion of 2002-08 saw the lowest annual growth in real non-residential investment in equipment and software and the lowest annual growth in employment despite record low short rates and lower-than-ought-to-be long rates. Japan is another prime example. It is the case because low rates alter expectations about future economic growth, for the worse.

Long rates may be explained by other factors but the principal factor is the short-term interest rate. Hence, if long rates did not rise much, despite strong US economic growth, it simply meant that the Fed could have done more with short rate hikes – both the pace and the quantum of rate rises between 2004 and 2006.

From William Buiter’s Maverecon blog post in 2008:

But the fact that on top of these very low risk-free long-term real rates, credit spreads became extraordinary low, had something to do with the liquidity glut created by the Fed, the Bank of Japan and, to a slightly lesser extent, the ECB. The Fed kept the Federal Funds rate target too low for too long after 2003. Because of the unique role played by the US dollar in the global financial system, the US dollar liquidity shower not only soaked the US economy, but also many others. First those who kept a formal or informal peg vis-a-vis the US dollar. Then those whose monetary authorities, without pursuing a dollar peg, kept a wary eye on the exchange rate with dollar, and ultimately most central banks in the globally integrated financial system. [Link]


Assertion 2: It is far from clear that Fed policy was driving indebtedness as Mr Klein alleges.

Response 2: It may not be clear only to ‘Free Exchange’.  Fed policy – in actions and in speeches – dismissed bubbles and the lax regulatory response too part of the Fed policy framework. More honest introspection is needed on the part of the bubble-blowing Federal Reserve and its cheerleaders.

Assertion 3: Direct foreign-exchange market interventions* in the early 2000s would have been highly stimulative (though not popular in foreign capitals). They would also have leaned against capital inflows, and limited growth in America’s current-account deficit and in private indebtedness.

Response 3: Direct or not, the Federal Reserve policy of cutting rates to 1.0% and keeping it there was a foreign exchange market intervention of sorts. The purchasing power of the Euro in terms of the US dollar doubled from the year 2000 (October) to 2007. A gain of little over 10% per annum. The dollar weakened against most currencies in the world. It was a foreign exchange market intervention and it stimulated global bubbles as all countries raced to counteract currency strength or mute it with expansionary (or, reluctantly tight) monetary policies of their own.

Assertion 4:  In 2003 the Fed was actively concerned about disinflation and the threat of deflation. Had it pursued a tighter policy path inflation would have moved even farther below trend. Now unless Japan is the financial stability ideal Mr Klein has in mind, one has to assume that he would support Fed action to actively combat deflation. But that would have meant moving interest rates down to 1% or below. It might also have meant use of unconventional policy; that was certainly something being discussed at the time.

Response 4: The Federal Reserve was wrong to have focused on disinflation. It relied on wrong data as it turned out. The following is an extract from Richard Fisher’s (Federal Reserve Bank of Dallas) speech in 2006:

A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent “lower boundary.” At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy’s ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth. [Link]

One could also rather reasonably hypothesise that the Federal Reserve was focused on asset prices, either implicitly or explicitly. The extraordinary decline in the Federal Funds rate to 1.0% and the year-long tenure of the FF rate at that level was due to the anxiety on the part of the Greenspan-Bernanke duo to support asset prices. Willem Buiter could not have put it any better than he did here:

It seems pretty self-evident to me that the Fed under both Greenspan and Bernanke has responded more vigorously with rate cuts to sharp falls in stock prices than can be rationalised with the causal effects of stock prices on household spending and private investment or with the predictive content of unexpected changes in stock prices.

To me, the LTCM and January 2008 episodes suggest that the Fed has been co-opted by Wall Street – that the Fed has effectively internalised the objectives, concerns, world view and fears of the financial community. This socialisation into a partial and often highly distorted perception reality is unhealthy and dangerous.

It can be called cognitive state capture, because it is not achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, the legislature or some important regulator, but through those in charge of the relevant state entity internalising, as if by osmosis, the objectives, interests and perception of reality of the vested interest. [Link]


Assertion 4:  It’s worth pointing out that America did not avoid crises over those 70 years by consistently using monetary policy to lean against any unusual credit growth. In the six decades prior to the 2000s the use of tighter monetary policy to restrain credit growth would have prevented zero depressions while also reducing nominal output growth.

Response 4: Mr. ‘Free Exchange’ sets up too many strawmen and knocks them down. No one can remotely credit Federal Reserve monetary policy with seven decade prosperity. Even the Federal Reserve Chairmen would be a little more modest than that! In the 1930s, Roosevelt’s interventions restored growth. For nearly five decades after that, the US financial sector operated under tight restrictions. That is why they could not create too many bubbles. It is no credit to the Federal Reserve. Further, the extraordinary damage caused to Japan and Europe in World War II gave a free pass to US exports as the world capacity was being rebuilt. There was so much spare capacity worldwide that no overheating risk arose for nearly two decades until the US over-reached in Vietnam and began to feel competitive anxieties versus Japan and Germany. The Federal Reserve created a washout of the Seventies with its accommodative monetary policies. In the 1980s, the Federal Reserve briefly created a painful slowdown with sky-high real interest rates and that laid the foundation for the next two decades of bullish asset prices.

So, the only instance when the Federal Reserve ran a tight monetary policy, it paid rich dividends for the next two decades (roughly). Hence, facts speak otherwise than what Mr. ‘Free Exchange’ would like us to believe.

Assertion 5: There is a limit, in other words, to the horizon over which the Fed has permission to sacrifice short-run growth for longer-run growth.

Response No. 5: The converse is equally true. There is a limit, in other words, to the horizon over which the Fed has permission to prioritise short-run growth over long-run growth. Five years of zero per cent interest rate and four years of money printing are well above what most people would regard as a legitimate horizon for monetary policy to try and influence short-run cyclical output.

Assertion 6: economic history provides us with some very clear lessons on the nature of monetary policy under conditions like those at present. With both nominal interest rates and expected inflation uncomfortably close to zero, caution is a recipe for underemployment and stagnation at best.

Response 6: Economic history provides us with some very clear lessons too on the limitations of monetary policy under conditions like those at present. Accepting one’s limitation is the starting point of the road to redemption. It is also a less hubristic response. Between 2002 and 2007, America borrowed economic growth from the future with an extraordinary credit bubble. Financial globalisation and financialisation inflated that bubble. Without clearing away all the debris of the previously collapsed structure, one cannot rebuild a future edifice.

Assertion 7: Fed officials’ determination to prematurely back off accommodative policy has repeatedly threatened to tip the economy back into recession. That, in turn, has forced the Fed to roll out even more unconventional accommodation. The Fed’s balance sheet is probably much larger now than it would have been had the FOMC been much more aggressive in 2009-10. QE3 will almost certainly continue for longer than it would have had the pro-tapering bunch simply kept their mouths shut in early 2013.

Response 7: Let us be very clear because Mr. ‘Free Exchange’ is trying to be clever. Tapering is not prematurely backing off accommodative policies. When the Federal Reserve initiated QE3, it was four years after it initiated its unconventional monetary policy. It was meant to be an insurance against any meltdown in the Eurozone. Tapering is now a small withdrawal of that additional stimulus. The Federal Reserve will still be buying assets in the market. Nor would it shrink its balance-sheet under tapering. Nor would the Federal Reserve be raising interest rates. If anything, it has further pushed out the date for the commencement of normalisation of monetary policy, even without commencing tapering in September 2013. The Federal Reserve Bank of San Francisco has said, in a research note, that QE achieved very little in terms of economic gains. Monetary policy did not risk becoming prematurely tight with tapering. It was going to become a little less ridiculous. That has not happened.

The problem with the ‘you can never have enough policy stimulus’ camp is that it refuses to admit that it has been proven wrong and there are limits to how far one can defy normal and natural laws of economics. For them, Schumpter did not exist. They are trapped in their delusions and hubris as to how much their policy interventions can achieve, ignoring how much their policy interventions are distorting all the time. Indefensible.

For an antidote to reading ‘Free Exchange’, please catch up with Gilian Tett here and here.

Free non-sense – 1/2

TGS has a particular fascination for the unabashedly interventionist streak exhibited by the blog, ‘Free Exchange’ hosted by ‘The Economist’ newspaper. The philosophical underpinning of that blog is that there is no problem in the world that cannot be fixed by a little lower interest rate and a little more government spending. There is always room for a rate cut or or money printing or government stimulus.

TGS finds very little to commend in such views. They are safely ignored. These bloggers go silent when their preferred solutions do not work or when the catastrophe they predict without more stimulus does not happen. Take Europe, for example. Even this blogger was surprised to see the massive improvement in Greece’ overall fiscal position and primary fiscal balance in the last three years. Greece has not imploded socially. The Euro is strong. In fact, it has quietly re-staked its claim to be the global reserve currency. Very few are taking note or acknowledging it. China must be disappointed at the resurrection of the Euro.

Yes, a lot can go wrong still. It is one thing to be able to face a crisis and it is another thing to start to grow from here, when global growth impulses are weak, for various reasons. This blog has discussed them repeatedly. The world has borrowed too much from future growth – literally and otherwise. It has to pay back. The repeated downgrade, by international agencies, of their global growth forecasts proves the point.  Growth has to be ‘snatched’ from others. That requires a ‘beggar thy neighbour’ exchange rate policy. The Euro is too strong for its own good. Otherwise, a lot more pain will be required to be borne for peripheral Europe to achieve real (as opposed to nominal) competitive gains. That might be pushing the luck too far.

Anyway, TGS is digressing here. The point is that, including TGS, not many anticipated the Euro to be trading at 1.35 to a U.S. dollar in October 2013 or that Greece would be achieving a primary surplus.

If any one spots a Keynesian (where is Mr. Krugman?) acknowledging the European/German austerity ‘success’ (I am still prepared to concede the dangers of pushing austerity too far without the safety valves of global growth and a temporarily cheaper currency and hence the inverted commas), please bring it to my attention.

Now that this post has already taken too much space, I shall use the second part to comment on the specific topic of U.S. monetary policy on which ‘Free Exchange’ has held forth expansively in a recent post.