Posts Tagged ‘recession’

something’s got to give

December 18, 2009

For all terms and purposes Greece is a country under a fixed rate regime. Yes, it is part of the Euro which is a freely floating currency, but in reality (i) Greece’s state or actions do not affect the Euro rate, apart from creating worries that other more systemically important countries might find themselves in choppy waters, and (ii) the largest part of Greece’s trade is with Eurozone partners, and this takes place on a fixed trivial Euro-to-Euro basis (55% of imports and 65% of exports are with EU partners, of which the bulk is with Eurozone members).

This implicit peg has served well as an anchor for inflation, but might not be optimal in the current circumstances. If one were to give an IMF-style advice to Greece, then one would probably recommend a currency devaluation or resetting the peg (as this IMF surveillance document points out, where advice is given this is towards more flexibility). It would not inflate the debt away, as this is denominated in Euro, but it will (i) improve the balance of payments in the short run, (ii) inflate away wages that are currently sticky, and (iii) reduce the size of the housing bubble which is also sticky due to the unwillingness of sellers to accept reductions. Perhaps this would have been already optimal in a beggar-thy-neighbor fashion, as recession hit the country.

Paul Krugman suggests, in the case of Spain, that the only option is for nominal wages to drop. This is the route that Ireland has taken, but Greece seems to be unwilling to follow due to pre-election commitments. Does that mean that for Greece the only remaining alternatives are (i) exit the Eurozone, get back to the old Drachma and devalue, or (ii) wait for the IMF to enter the frame and force the wage cuts that the government will not?


They told us that they told them to lend

April 1, 2009

James Hamilton in a brilliant post discusses the recent expansion of the monetary base.

As it stands, the Fed has bought an array of securities from the banks, of a varying degree of toxicity. They did not go to the bank headquarters with a truckload of money, they, sort of, wrote a check or an IOU.

Every bank is required to keep some reserves with the central bank. In that way they force banks to keep some of their assets in cash form, thereby reducing the risk of banks over-leveraging themselves (or at least that was the principle). In order to buy these dodgy assets, the Fed did not actually pay for them, they just extended the reserves of the corresponding banks, without the banks putting any money themselves.

To make things more concrete, say that Pitibank is required to keep USD50 with the Fed as reserve. Also, say that the Fed decided to buy from them a bunch of mortgages (of face value USD300), but which they agree to buy at USD200. These are “toxic” because if the bank sold them in the market, then at the moment they cannot find a buyer that will pay more than USD30.

The Fed gets these mortgages from Pitibank, and instead of paying in cash, they just increase Pitibank’s reserve to USD250. It is essentially the same thing, since Pitibank can draw from these reserves if they want to (down to the requirement of USD50). The Fed will then essentially “print” money to give Pitibank when asked.

What politicians are telling us, is that they want banks to start lending again. This essentially means that they want Pitibank to ask for these reserves and lend the money to individuals, small businesses and each other.

But banks don’t appear to be doing that. They prefer to let the money in their reserves with the Fed. Why do they do that? Are they keeping good money idle? Well not really, because the Fed has decided to actually pay interest on these reserves. This increases the opportunity cost of lending the money to you and me, and acts as a dis-incentive for Pitibank.

Does that make sense? Well, no matter what the politicians are saying, central banks are having nightmares of all that money reaching the consumers and sparking inflation. As J Hamilton points out, doubling the monetary base will eventually translate into 100% inflation: all prices will double.

It seems to me that with that interest rate on the reserves, the Fed is trying to control how fast this huge amount of money reaches the real economy. And they don’t seem to be very keen for this to happen.

King Henry and his mint-men

March 30, 2009

Henry gives a lesson on how to deal with rogue bankers, as described in the Anglo-Saxon chronicle. A G20 special

A.D. 1125
In this year sent the King Henry,
before Christmas, from Normandy to England,
and bade that all the mint-men that were in England
should be mutilated in their limbs; that was,
that they should lose each of them the right hand,
and their testicles beneath.
This was because the man that had a pound
could not lay out a penny at a market.
And the Bishop Roger of Salisbury
sent over all England, and bade them all
that they should come to Winchester at Christmas.
When they came thither,
then were they taken one by one,
and deprived each of the right hand
and the testicles beneath.
All this was done within the twelfth-night.
And that was all in perfect justice,
because that they had undone all the land
with the great quantity of base coin.

(from Private Eye)

barclays’ creative accounting

February 10, 2009

Barclays announced that they made a profit to the market’s delight. It is interesting to see where this money comes from, and which part is actually real.

The announcement document hides a few real gems.

On page 7, fourth bullet point, one reads that Barclays books “gains on own credit £1663m”. And this amount is clarified on page 29, naked in all its glory, as “[…] gains of £1663m (2007: £658m) from the general widening of credit spreads on issued notes by Barclays Capital”

What does that mean? Well Barclays have issued bonds that other market participants bought. These bonds are promises, made by Barclays, to deliver a fixed amount in the future.

Say that the amount is GBP100. This GBP100 are clearly a liability for Barclays, but now they are making the following claim:

Well we might default in the near future, in which case the debt is forgiven and bondholders take zip. The credit spread quotes put a price on this default probability, say that they imply a probability of 5%. Then, according to the current accounting standards, we don’t really have a liability of GBP100 but a liability of GBP95 only. So compared to last year when our default probability was negligible we have made a gain of GBP5.

What is the bottom line? the higher our probability of default => higher probability that our debt is forgiven => lower current value of our debt => higher gain we book. Nice!

This blog is doing a good job in explaining the rationale behind the standards that allow such acrobatics.

There I found the quote: “If your own credit spread widening counts as revenue, and you pay compensation as a percent of revenue, the most profitable and lucrative day in the history of your firm will be… THE DAY YOU GO BANKRUPT!

W Buiter, on the other hand, goes berserk about that. He calls it “mark-to-market gone mad”.

A similar construct appears in counterparty risk management a’la Basel II, where capital can be released as one becomes a worse counterparty.

my wife wants a cooker

January 26, 2009

My wife wants a new gas cooker, and as a decent husband I took her down the shops to choose. We went around the usual stores, including Currys and Comet, the largest white goods retailers in the country.

After doing the rounds, a very interesting pattern started to emerge: pretty much all cookers that we asked for were out of stock. This was true even for items that were on discount, which we found a bit bizarre. The sales guys seemed to have no clue as to when they would come back on, with most of them guessing a four to six week wait. They were all keen to point out that we should nevertheless put our order forward, in order to secure our enamel dream.

Now as an expert in all things financial, I thought it would be interesting to check the stock and CDS prices for DSG International (owner of Currys) and Kesa (owner of Comet).

The CDS price is the insurance premium one would pay to protect themselves against a company defaulted. Typically it is used by bondholders as insurance (but, as you might have noticed, all sorts of unscrupulous financiers have been speculating with that stuff recently). Nevertheless, for DSGI the CDS quote was a whopping 18%. This means that if I want to buy insurance for DSGI bonds that promise to pay me EUR100, the premium would be EUR18 per year. Now that’s quite a lot of money, which means that someone believes that these guys might actually default. In fact, the implied probability of default would be at least 18% per year, depending on what proportion of the EUR100 I will be able to recover if DSGI default. With the standard 40% recovery assumed in the market, the default probability is an amazing 30%. This is roughly 2.5% per month.

To recap, some guy wants to sell me a cooker he doesn’t actually have yet. Actually, as far as I could tell, he doesn’t seem to have many cookers at all. But he nevertheless wants me to pay more than 500 quid in advance for it, in full. He promises that he will go and get it for me in the next couple of months, but there is a decent chance that he will make a runner.

Is this how we are going to get ourselves out of this mess? No way mate.

(Unfortunately –or fortunately– Kesa don’t have CDS contracts, and for that reason I could not replicate the analysis. The same is true for Home Retail Group that own Argos.)

bailing out greece

January 14, 2009

Standard and Poor’s today downgraded Greece to A-, which was largely expected. Although Greece is a member of the Eurozone, S&P see the increasing deficit as a problem. And arguably, a bigger problem is that although Greece has experienced some remarkable growth in the last few years, the deficit issue was not adequately addressed by the government. In fact Greece has one of the highest public debt to GDP ratio in the world, and topping that with one of the worst current account deficits does not really help.

The folks at the have a very interesting recent presentation which touches on the matter. On p.11 there is a discussion on who would bail out Greece in case of troubles (either deserved or undeserved). As I understand it, their point is that no institution will be interested or capable of rescuing the Greek economy. They also see some cracks appearing in the <<weakest link>> of the Euro area.

And Greece will need to go to the global credit markets for EUR50bn+. Only yesterday they raised a mere EUR2.5bn, amidst higher spreads, which are now about 250bps (2.5%) above the German yield. Now they will have to raise 20 times that amount.

Should we expect spreads shooting up and Greece defaulting on the existing debt as a result of its inability to roll over? A speculative attack on Greek bonds? A test for the euro?

An IMF document discusses the Greek economy. Overall Greece is exposed to south-eastern Europe and the Balkans, which is not surprising. What surprised me is what a crap job Greek banks do within Greece, with such a high percentage of non-performing loans recorded in a boom period. I can only guess the quality of the loans that they have given in Albania, Romania and Serbia…

the lost decade

January 2, 2009

In the last few months there have been scores of comparisons of this crisis with the Japanese “lost decade” and the Great Depression of the early 20th century. But what, if anything, have we learned from these disasters?

Of course there are similarities between the current crisis and both episodes. N Roubini’s description of the Japanese economy of the 90s reads scarily like a description of the current environment [at least] in the UK. In particular, the UK exhibits all symptoms that Roubini finds in Japan of the late 90s:

* Poor growth: The UK economy has been shrinking, and is also forecast to shrink further. The same is true for the US and most Eurozone economies. Growth expectations on the BRICs are getting revised downwards every week or so.

* Fiscal problems: Increasing budget deficit, with the 2008 figures being double the 2007 ones. The Debt/GDP ratio jumped from about 35% to nearly 45%, well above Gordon Brown’s self imposed ceiling of 40%. [national statistics figures]. Granted, these figures are well below the Japanese levels given in Roubini, but our recession just started, while his Japanese figures are essentially after a decade. But if we position ourselves in Japan of 1990, around the beginning of their recession, then the Japanese debt/GDP ratio of 47% is roughly the one we experience today. [OECD data]. The “quantitative easing” implemented by Japan, which is a euphimism for “credit card maxing”, is a policy that is widely advocated today. This led eventually to record debt levels for Japan, which is now established in the top five most indebted countries, in the company of fiscal policy pioneers like Zimbabwe and Jamaica.

* Weak labour market: Unemployment is steadily rising in the UK, with the psychologically important threshold of three million unemployed now forecasted, a value reached in 1982 and back in the 1930s.

* Weak trade: UK is a net importer, to the tune of $120 billion. A retreating stirling will therefore have a large impact on future current account deficits. Under other circumstances a weak currency would boost exports, but unfortunately three quarters of the UK GDP are in the services sector, with a large chunk in banking and finance which is hit the most. The collapse of the stirling, which is now near parity with respect to the Euro, indicates just that.

* Loose macro policy: Monetary policy is loose, with interest rates at very low levels and expected to drop further. A fiscal expansion is on the cards, as an attempt to help growth.

All these are symptoms that Roubini found in the Japanese economy after a decade of non-growth. The UK, and I guess the US and the Eurozone, are not far out, but our recession has just begun.

Roubini blames the Japanese way of doing things: heavy regulation and government intervantion, the keiretsu system of corporations that are expected to help each other, the concept of job security. Overall, Roubini contrasts the traditional risk averse Japanese to the risk-taking Americans. To save Japan from the spiral she finds herself in, Roubini advocates market liberalization in bank structures, financial derivatives and insurance products, deregulation, and enhanced competition.

But guess what: the current North Atlantic crisis [as W Buiter rightly calls it] is a crisis that exhibits the same set of symptoms, but is concentrated in economies that have been exponents of Roubini’s policy. We have experienced liberal laissez faire, deregulated markets, we were ardent proponents of financial innovation and devised a plethora of tools that were supposed to augment our risk sharing abilities. We worked on the basis that when it comes to government smaller is better, and we even assigned large chunks of the regulatory supervision to rating agents. And we don’t seem to be that far from the Japan of the mid 90s.

A number of economists, including the latest Nobel winner P Krugman, blame Japan’s central bank for not reducing the interest rates to zero fast enough to create inflationary expectations early on. I presume this is behind the unprecedented speed at which the Fed lowered the target rate down to zero.

According to their models the real problem is what is called a liquidity trap: essentially a small inflation is a nudge for people to spend now, rather than next year when the goods will be more expensive. If individuals expect prices to fall, then they might postpone their purchases to take advantage [think of waiting for the post-christmas sales, or waiting three months to buy the memory stick you spotted online, but on a larger scale]. If the majority behave like that, then the cogs of the economy stop turning. Households are just hoarding money, waiting for the prices to fall.

In such models monetary policy is ineffective, which is the case at the moment, where short term interest rates are virtually zero. This is where quantitative easing comes into play, with the government boosting demand [since households are in the liquidity trap and are unwilling to do so]. By spending money, the government creates inflation and pushes households out of the liquidity trap: they now see things getting more expensive and start purchasing again.

Japan tried it 10 years ago, amassed a huge debt, and is still in recession.

So what have we learned? (1) The underlying system is irrelevant: having a liberalized system with swaptions, credit default swaps and CDOs does not offer any protection. (2) Inflation targeting can work against the stability it was devised to enhance. (3) Japan was in that predicament and tried both monetary and fiscal measures. She is still there, but with a huge debt burden on top of low growth. At least Japan is a net exporter, something that we are certainly not.

There are many other ideas floating around: from droping fiat money and getting back to a commodity backed currency system, to the Fed pegging not only the risk free rate of return, but the whole yield curve and even an equity index like the S&P500. There is this quote on opinions and assholes, but I will not dwell further on it as there is some debate going on regarding its validity.