It is becoming to be quite evident that control of short term interest rates by central banks is prone to be a cause of market disturbances, including speculative manias and crashes. Financial bubbles have of course existed much before the existence of central banks. The current problem, however, is a common problem in situations where prices are set by a third party that is not fully in control of supply. Such price controls cause both rampant overproduction or overconsumption and shortages, depending on whether the prices are set too low or too high.
Central banks used to be in control of the supply of money, but since the early eighties, they have given this power away by drastically reducing reserve requirements of commercial banks. This means that commercial banks are now primarily in charge of the development of the money supply.
This divergence between the power to control prices and the power to control supply is inherently unstable, so we have to go back to the old days of strict control of bank lending, or we have to go forward to release short interest rates from the clumsy control of central monetary authorities.
Central banks seem to be aware of their loss of control, but there does not seem to be much thought about what this implies. Price controls by decree without control of supply have been found to be a bad solution to economic problems.
Discussion of the possibility of US Federal Reserve paying interest on bank reserve balances has been a hot topic earlier this month. The Fed seems to be working towards implementation of an interest rate corridor policy, which has already been adopted in Canada, UK, and New Zealand.
In this system, the central bank sets both a lower and an upper bound for the interest rates of over-night inter-bank loans. This is accomplished by paying a minimum interest on cash balances at the central bank. There is no reason for banks to offer loans to other banks on interest any lower than that. The upper limit is the discount rate, at which banks can borrow directly from the central bank.
A 2006 paper titled "Monetary Policy Implementation Without Averaging or Rate Corridors" by William Whitesell discusses a third alternative for monetary policy application, but the focus of this paper is hopelessly fixated on how the central bank could fix the inter-bank interest rates as tightly as possible. What is missing is any discussion of the sense in trying to achieve such a rigid goal in the first place.
My intuition would tell me that a fixed interest rate for short term lending is inherently a bad thing. Lending rates should accurately reflect the existing earning opportunities and costs of investment activity. A misalignment between opportunities and policy rates create bubbles of hyper-active speculation, because of seemingly risk free opportunities for arbitrage between short term borrowing and lucrative investment opportunities. On the other hand, a misalignment between costs and policy rates create unnecessary slow-downs in investment and savings.
An ideal would be a market-determined interest rate that would dynamically reflect changes in actual opportunities and costs. When a dislocation would suddenly create an investment opportunity, there is always a risk of a speculative bubble. Short term interest rates should react swiftly to sudden increases in demand for credit. If the opportunities are real, it is only just that the savings customers of banks get their fare share of the investment income. If the opportunities are a mirage, the sudden rise in interest rates would quickly deflate the emerging speculative bubble without letting it gather too much steam.
I have been thinking of a mechanism by which central banks could fulfill the function that they were created for, ie. liquidity support, without actually engaging in direct control of interest rates.
First let's be clear about what liquidity actually is. Liquidity is a multi-faceted concept. It has something to do with the volume of trade. It has something to do with transaction costs. Liquidity is not a synonym for lack of volatility, which is possible in perfectly liquid assets.
Liquidity can probably be best described by insensitivity of market prices to a unit volume of trade transactions. It is also related to the amount of losses incurred by simultaneous buying and selling in a single market.
In a trading system there is a certain volume of bidding and asking at different prices. In a real time system, there is a gap between these. This bid-ask spread can be used as a quite reliable measure of liquidity.
I have been thinking of a liquidity provision system through a dynamic interest rate corridor. Instead of a policy rate, set by a committee, the central rate of the corridor would be based on a market average.
In such a system, all interbank lending would pass through a transaction system that is managed by the central bank. The central bank gathers pricing information from this system, and determines an average market price. A suitable margin is then put around the central rate to determine an interest rate corridor. This corridor guarantees a maximum bid-ask spread, ie. a minimum liquidity, at with banks can directly transact with the central bank.
The central rate could be calculated by taking a significant amount, say $100 million, of both the highest asking rates and the lowest bids. By taking a weighed average of these, a neutral market rate would be determined. A meaningful bidding amount should be used for the determination to prevent market manipulation with insignificantly small bids.
Banks would be free to transact with the central bank at the corridor rates, but they could still get better rates by bidding inside the corridor. The corridor should be wide enough for everyday trading to occur between the market participants. But in times of uncertainty, when the spread would otherwise be stretched uncomfortably wide, there would still be a guarantee of minimum liquidity from the central bank.
In times of stress, such a market-based interest rate would be equally uncomfortable to both sides of the market, which is as close as one can get to neutrality. A strictly enforced policy rate, on the other hand, can create highly biased situations, in which either the lender or the borrower would benefit at the expense of the other.
I am quite completely ignorant of most issues of monetary policy, but I would hazard a guess that the level of activity in such a dynamic interest rate corridor could be used as a measure of monetary conditions. Persistent borrowing from the central bank could be a sign of the need for increasing reserves. Persistent deposits would signal a need for reduction.
May 24, 2008
May 5, 2008
Commodity Inflation and the Missing Wage/Price Spiral
Why are commodity prices rising worldwide? What does that do to western inflation pressures?
Permanent inflation is not possible without a wage/price spiral (the more usual term wage/price spiral has the cause and the effect backwards). There might be such a thing in China, but not in the strength that some foodstuffs have risen lately. In the US there seems to be no such thing, except for an insignificant 1 percent of the population. This fraction might be significant enough for gold, maybe, but not for other commodities.
So clearly this price growth is at least partly a financial phenomenon. I would say that it has been probably started by a spurt of speculative growth, based on a limited underlying fundamental scarcity, a surge of short term credit from central banks and a dearth of better speculative prospects. After all, one can't do much other than speculate on short term capital.
But this speculative start was most probably amplified by sudden hoarding by actual consumers, who were frightened by the initially speculative price surge. This hoarding has generated an actual (but temporary) shortage in some basic foodstuffs, like rice and wheat.
Some people, like Paul Krugman, have proposed that inventory levels do not support the speculative hypothesis. I think he is pretty much right when it comes to the gradual price development of oil and metals. But I think that the unofficial inventories created by simple consumer hoarding, which is just as speculative as anything, is quite enough to explain the extreme price movements of basic foodstuffs.
Let's study another example: Was there a big inventory of houses as a sign of the growing speculative bubble? No, there was a perceived shortage of houses, caused by consumer hoarding, ie. the inventory was held by the house flippers. The same goes with foodstuffs, and might go on with metals as well. End users are always hoarding somewhat when there is an expectation of price increases.
Such hoarding can create a false signal of shortage, which can then be met by a surge of overproduction and a price collapse, when consumers have filled their cupboards and return to normal consumption. When prices stabilize, they start to unwind their inventories, which results in a fall in demand to even lower levels than the actual consumption. This gives the consumers incentive to draw down their inventories as low as possible in expectation of further price reduction.
So what will happen in the western world where any evidence of a wage/price spiral just isn't there. An equation of rising cost of living with stagnant wages is not sustainable in the long term. In the Western world, there are, of course, significant "buffers" until people start to go hungry. What if we add ever extending credit into this equation? Growing debt repayment makes this equation even more unsustainable, as in prone to a violent snap-back effect. Credit is no substitute for income.
As wages are not going to grow, either prices or consumption must (eventually) come down. Debt will be simply defaulted on. People haven't understood that "free money" only refers to the interest, not the principal. One can not consume something today without giving up something tomorrow. If nothing else, then your credit score.
Unless wages are going to follow prices, there is going to be an eventual price deflation, no matter how much baseless credit is extended. US monetary base has been stagnant for two years. The Chinese have probably prevented massive printing with the nuclear option of massive Treasury liquidations.
An ounce of gold is always going to be worth an ounce of gold. There is no reason why its value should change (or not change) very much against other durable if nonproductive assets, including little green pieces of paper that can be used for paying taxes. But there are precious few (0.8 trn) pieces of green paper, compared to the mass of promises to deliver those pieces of paper on a later date (25 trn).
In these circumstances, the value of those few little green papers might actually rise significantly. But wouldn't that be an intolerable atrocity, because those little green papers are just little green papers, right? They can't be used to produce anything, except that special something, which until recently used to be called "AAA". But nowadays everybody knows what those three vowels really stand for, and that ain't much. So isn't it just appropriate that those little green papers should lose their value along with the worst of IOUs written on a paper napkin with lipstick?
Don't let yourself be fooled. Good credit still exists, even though "AAA" has lost its significance. Looking at how US stores have become a bargain basement for foreigners, it seems that the US dollar does have some value after all. Dollar has been getting a lot cheaper, but has it really lost value? That of course depends entirely on what you are going to buy. ("Price is what you pay. Value is what you get.")
BTW, since GDP is a measure of added value, shouldn't US GDP statistics for the last ten years be revised downwards for the "value" that is now melting away from housing? That value was never actually created, after all. It was just a pricing mistake. Think about that.
Since the instruments of exchange (promissory notes, not to be confused with cash) that were used to create those imaginary valuations are still in circulation, they will find a home somewhere else, like basic commodities. But those are still just promissory notes. They are not little pieces of green paper. I guess the Federal Reserve could convert all kinds of promissory notes to little green pieces of paper, but that wouldn't do the US external credit very much good at all.
So first the US economy was producing value in dotcoms, then in housing, then in commodities. Then what? How much of all that added value still exists? Maybe a little more than the value of a pair of collapsed Bear Stearns hedge funds. But all is fine as long as the fund managers get their 2 and 20 from each successive bubble.
Permanent inflation is not possible without a wage/price spiral (the more usual term wage/price spiral has the cause and the effect backwards). There might be such a thing in China, but not in the strength that some foodstuffs have risen lately. In the US there seems to be no such thing, except for an insignificant 1 percent of the population. This fraction might be significant enough for gold, maybe, but not for other commodities.
So clearly this price growth is at least partly a financial phenomenon. I would say that it has been probably started by a spurt of speculative growth, based on a limited underlying fundamental scarcity, a surge of short term credit from central banks and a dearth of better speculative prospects. After all, one can't do much other than speculate on short term capital.
But this speculative start was most probably amplified by sudden hoarding by actual consumers, who were frightened by the initially speculative price surge. This hoarding has generated an actual (but temporary) shortage in some basic foodstuffs, like rice and wheat.
Some people, like Paul Krugman, have proposed that inventory levels do not support the speculative hypothesis. I think he is pretty much right when it comes to the gradual price development of oil and metals. But I think that the unofficial inventories created by simple consumer hoarding, which is just as speculative as anything, is quite enough to explain the extreme price movements of basic foodstuffs.
Let's study another example: Was there a big inventory of houses as a sign of the growing speculative bubble? No, there was a perceived shortage of houses, caused by consumer hoarding, ie. the inventory was held by the house flippers. The same goes with foodstuffs, and might go on with metals as well. End users are always hoarding somewhat when there is an expectation of price increases.
Such hoarding can create a false signal of shortage, which can then be met by a surge of overproduction and a price collapse, when consumers have filled their cupboards and return to normal consumption. When prices stabilize, they start to unwind their inventories, which results in a fall in demand to even lower levels than the actual consumption. This gives the consumers incentive to draw down their inventories as low as possible in expectation of further price reduction.
So what will happen in the western world where any evidence of a wage/price spiral just isn't there. An equation of rising cost of living with stagnant wages is not sustainable in the long term. In the Western world, there are, of course, significant "buffers" until people start to go hungry. What if we add ever extending credit into this equation? Growing debt repayment makes this equation even more unsustainable, as in prone to a violent snap-back effect. Credit is no substitute for income.
As wages are not going to grow, either prices or consumption must (eventually) come down. Debt will be simply defaulted on. People haven't understood that "free money" only refers to the interest, not the principal. One can not consume something today without giving up something tomorrow. If nothing else, then your credit score.
Unless wages are going to follow prices, there is going to be an eventual price deflation, no matter how much baseless credit is extended. US monetary base has been stagnant for two years. The Chinese have probably prevented massive printing with the nuclear option of massive Treasury liquidations.
An ounce of gold is always going to be worth an ounce of gold. There is no reason why its value should change (or not change) very much against other durable if nonproductive assets, including little green pieces of paper that can be used for paying taxes. But there are precious few (0.8 trn) pieces of green paper, compared to the mass of promises to deliver those pieces of paper on a later date (25 trn).
In these circumstances, the value of those few little green papers might actually rise significantly. But wouldn't that be an intolerable atrocity, because those little green papers are just little green papers, right? They can't be used to produce anything, except that special something, which until recently used to be called "AAA". But nowadays everybody knows what those three vowels really stand for, and that ain't much. So isn't it just appropriate that those little green papers should lose their value along with the worst of IOUs written on a paper napkin with lipstick?
Don't let yourself be fooled. Good credit still exists, even though "AAA" has lost its significance. Looking at how US stores have become a bargain basement for foreigners, it seems that the US dollar does have some value after all. Dollar has been getting a lot cheaper, but has it really lost value? That of course depends entirely on what you are going to buy. ("Price is what you pay. Value is what you get.")
BTW, since GDP is a measure of added value, shouldn't US GDP statistics for the last ten years be revised downwards for the "value" that is now melting away from housing? That value was never actually created, after all. It was just a pricing mistake. Think about that.
Since the instruments of exchange (promissory notes, not to be confused with cash) that were used to create those imaginary valuations are still in circulation, they will find a home somewhere else, like basic commodities. But those are still just promissory notes. They are not little pieces of green paper. I guess the Federal Reserve could convert all kinds of promissory notes to little green pieces of paper, but that wouldn't do the US external credit very much good at all.
So first the US economy was producing value in dotcoms, then in housing, then in commodities. Then what? How much of all that added value still exists? Maybe a little more than the value of a pair of collapsed Bear Stearns hedge funds. But all is fine as long as the fund managers get their 2 and 20 from each successive bubble.
March 12, 2008
Unfair competition from Northern Rock
From The Guardian:
Northern Rock offers a number of table-topping accounts, including an online account aimed at the over-50s paying 6.49% and a fixed-rate cash Isa with a rate of 6.2%. Its one and three-year fixed-rate savings bonds paying 6.45% and 6% respectively are also listed as best buys on the website of the financial data provider Moneyfacts.Ugh. "Give us your money. The UK taxpayer will be glad to give you a handsome return on you deposit."
Not only are the interest rates good, the state-owned Northern Rock, unlike other high street banks and building societies, can offer its customers a guarantee that any money in its accounts - whether it is £1 or £1m - is 100% secure.
The bank says its customers' cash is "completely safe ... The Bank of England and HM Treasury guarantee arrangements protect all savers in all accounts, regardless of the amount deposited, and applies to all existing and new accounts".
More Shortsighted Dollar Speculation
From FT.com:
When US deflation hits in force--because US financial institutions have no choice but to reduce leverage--the dollar will start to regain its value. Of course, it might take a long time for the euro-bubble to pop, but it will happen.
For EADS this might be feasible, because much of its income is in dollars as well, but there's no doubt that those suppliers will put considerable risk premiums into their bids for the currency volatility.
EADS, the Franco-German aerospace group, is preparing to adjust to a “weaker and weaker US dollar” by demanding that its big European suppliers bid for new contracts in the US currency, according to Louis Gallois, chief executive.Not a good idea when the US dollar is in its weakest. Euro seems more and more like a bubble against the US dollar.
When US deflation hits in force--because US financial institutions have no choice but to reduce leverage--the dollar will start to regain its value. Of course, it might take a long time for the euro-bubble to pop, but it will happen.
For EADS this might be feasible, because much of its income is in dollars as well, but there's no doubt that those suppliers will put considerable risk premiums into their bids for the currency volatility.
February 21, 2008
European Companies Are Borrowing in Dollars
Financial Times reported about European companies borrowing in dollars:
European money supply growth has been much higher than its US counterpart, especially in the narrow sense, and the emerging deflationary environment is just raising the actual buying power of the US dollar.
Europe is fundamentally just as over-leveraged as the US. The possibility of a deflationary trend in Europe should not be dismissed as a possibility, at least when it comes to the property markets. The biggest differences are in the levels of consumer debt. High corporate leverage is not as prone to cause deflation as excessive consumer debt is. UK is closer to the US in this sense, but it is not a part of the European monetary union.
European companies are increasingly being forced to turn to the dollar markets to raise funding as the credit crunch makes it almost impossible for them to launch deals in the euro-denominated market.This is going to hurt these European debtors when the euro inevitably comes down from its overly high valuation. The draught in euro-denominated bond investment is probably a sign of disbelief in the sustainability of the euro's high exchange rate against the dollar.
European money supply growth has been much higher than its US counterpart, especially in the narrow sense, and the emerging deflationary environment is just raising the actual buying power of the US dollar.
Europe is fundamentally just as over-leveraged as the US. The possibility of a deflationary trend in Europe should not be dismissed as a possibility, at least when it comes to the property markets. The biggest differences are in the levels of consumer debt. High corporate leverage is not as prone to cause deflation as excessive consumer debt is. UK is closer to the US in this sense, but it is not a part of the European monetary union.
January 19, 2008
About the Theory of Efficient Markets
I have just read a book, The Crisis of Global Capitalism, by George Soros. It was written in 1998, but oh so fit for 2008. Soros is a critic of the efficient markets hypothesis. I think he is right in saying that markets do not succeed in finding a balanced state, but act instead like a wrecking ball that swings uncontrollably around a point of stability.
In this book he describes a phenomenon, which he refers to as reflexivity. In systems that are made up of humans, like all markets obviously are, the ground truth is not independent from those that are trying to observe it. Instead, there is a constant bidirectional relationship between the observers and the observed. Similar problems are encountered in observing elementary particles, hence the Heisenberg uncertainty principle.
The book was written as a reaction to the Asian financial crisis and the Russian collapse. These events started a strong flow of capital to the established capital centers of New York and London. These flows made up the peak of the tech bubble. They were further prolonged by loose monetary policy. Now we are observing the turning point, where the wrecking ball hits the wall and turns back towards the point of stability.
If we want to actually reach the point of stability and stay there, there would have to be some kind of forces that would slow down the velocity of the ball while it speeds towards the point of stability. At the current situation, the global financial system is like a car without shock absorbers.
Every automation engineer knows that dampers are essential for stability. Why is it so hard for economists to realize that?
In this book he describes a phenomenon, which he refers to as reflexivity. In systems that are made up of humans, like all markets obviously are, the ground truth is not independent from those that are trying to observe it. Instead, there is a constant bidirectional relationship between the observers and the observed. Similar problems are encountered in observing elementary particles, hence the Heisenberg uncertainty principle.
The book was written as a reaction to the Asian financial crisis and the Russian collapse. These events started a strong flow of capital to the established capital centers of New York and London. These flows made up the peak of the tech bubble. They were further prolonged by loose monetary policy. Now we are observing the turning point, where the wrecking ball hits the wall and turns back towards the point of stability.
If we want to actually reach the point of stability and stay there, there would have to be some kind of forces that would slow down the velocity of the ball while it speeds towards the point of stability. At the current situation, the global financial system is like a car without shock absorbers.
Every automation engineer knows that dampers are essential for stability. Why is it so hard for economists to realize that?
Credit Default Swap Counterparty Risk
The enormous amount of counterparty risk that is associated with the $45 trillion market in credit default swaps seems to be finally hitting the radar screens of mainstream news outlets. Unfortunately this reporting interest is way behind the curve, as the said counterparty risk is being triggered in a big way in the problems of the ACA Financial Guaranty Corp.
The Wall Street Journal published a front-page article titled "Default Fears Unnerve Markets" by Susan Pulliam and Serena Ng. It is an excellent overview of the troubled CDS market.
The current problems are all derived from the proliferation of belief in the efficient market hypothesis. This theory, which posits that market valuations carry meaningful information about the real world, is basically self-defeating.
A high proportion of credit market participants look at prices, believing that those prices actually represent expectations of future defaults, which they do, initially. Then those market participants start to make investment decisions based on the price level, resulting in even smaller risk premiums. These same investors now think that the reduction in risk premiums is a signal of lower risk, even though the price reduction was caused by their very own uninformed investment decisions.
This is just like Winnie the Pooh following his own tracks in the snow, round and round again, until a moment of truth arrives. The music stops, and some of the players are left without seats.
The Wall Street Journal published a front-page article titled "Default Fears Unnerve Markets" by Susan Pulliam and Serena Ng. It is an excellent overview of the troubled CDS market.
Today, a struggling bond insurer, ACA Financial Guaranty Corp., will ask its trading partners for more time as it scrambles to unwind more than $60 billion of insurance contracts it sold to financial firms but can't fully pay off, according to people familiar with the matter. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own.This is the reason why some deals that looked like "free lunches" in February 2007 are not so free after all.
The problem is that the insurer itself is teetering -- with repercussions across the financial world. Some of its trading partners, called counterparties, already are writing off billions of dollars because of its inability to pay.
With many bond values falling and defaults rising, especially in the mortgage arena, some institutions involved in these trades are weakened. This has investors and regulators worried that, through such swaps, some market players could spread their own problems to the wider financial system.What the article omits, though, goes even further. It doesn't mention that a very big part of these CDS contracts are written by synthetic CDOs that are by definition not prepared for major payments at all. If they were, they would not have been closed in the first place.
"You are essentially counting on the reliability of strangers" to pay up on their contracts, notes Warren Buffett, the Omaha billionaire. In some cases, he says, market players can't determine whether their trading partners have the ability to pay in times of severe market stress.
The current problems are all derived from the proliferation of belief in the efficient market hypothesis. This theory, which posits that market valuations carry meaningful information about the real world, is basically self-defeating.
A high proportion of credit market participants look at prices, believing that those prices actually represent expectations of future defaults, which they do, initially. Then those market participants start to make investment decisions based on the price level, resulting in even smaller risk premiums. These same investors now think that the reduction in risk premiums is a signal of lower risk, even though the price reduction was caused by their very own uninformed investment decisions.
This is just like Winnie the Pooh following his own tracks in the snow, round and round again, until a moment of truth arrives. The music stops, and some of the players are left without seats.
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