Saturday, May 19, 2012

Credibility & the Fed

Let's get right to it. The Fed has no credibility. Not just now, but in the whole course of its history.

At least not if we define central bank credibility the way the economics literature does (Kydland & Prescott, Barro & Gordon), as the ability to overcome the time inconsistency problem.

This is a fundamental problem of central banking: All the Fed can do is maximize its current period utility function. Bernanke saying we will keep rates low till late 2014 is like Lucy telling Charlie Brown to go ahead and kick the football while she holds it steady.

Since nothing makes the Fed actually do in the future what they say they are going to do, no one has any incentive to believe the pronouncements (Charlie Brown if you are out there, pay attention to this post)!

But you say, inflation targeting worked!

People, inflation targeting is so incredibly powerful that it even worked in countries that DID NOT ADOPT AN INFLATION TARGET!

Here's the abstract from a 2007 paper in the Journal of Monetary Economics (Does inflation targeting really make a difference? Evaluating the treatment effect of inflation targeting in seven industrial countries by Shu Lin and Haichun Ye):

We evaluate the treatment effect of inflation targeting in seven industrial countries that adopted this policy in the 1990s. To address the self-selection problem of policy adoption, we make use of a variety of propensity score matching methods recently developed in the treatment effect literature. Our results show that inflation targeting has no significant effects on either inflation or inflation variability in these seven countries. Further evidence from long-term nominal interest rates and income velocity of money also supports the window-dressing view of inflation targeting.

Inflation and its volatility did not fall in the 90s because the adoption of inflation targeting gave central bankers credibility. "Good luck" is a more convincing reason for the outcomes than inflation targeting.

This point cuts both ways.  Yes, it implies that the expectational miracle the market monetarists expect to ensue from the Fed unilaterally announcing a target path for NGDP is unlikely. But it also implies that all the Fed talk about "losing hard-won credibility" and "expectations might become un-anchored" is meaningless as well.

There is no anchor.

Friday, May 18, 2012

Are you ready for a miracle?

Is Greece the Lehman Brothers of Europe?

It looks like Greece is going to finally call Germany's bluff. The head of the party projected to win a plurality in the June election (Alexis Tsipras, head of Syriza), wants no part of the agreed upon package and expects Germany to keep financing Greece with few to no conditions or else they will simply default on everything.

It's a shame for them they didn't do this a lot sooner when they had more leverage. German and French banks have had several years to write down or otherwise reduce their exposure to Greece.

Given this reduced direct leverage and all the rhetoric from Germany and the ECB, things may come to a head this summer.

Will Germany let Greece go the way Paulson and Bernanke let Lehman Brothers go?

If so, will they be able to contain the fallout and be able to keep Spain (and Italy) in the EZ?

I say it's 60% that Greece goes this summer and 60% that no one else does over the next year.

One thing that is 100%: we are living in interesting times.

A Parable of Modern Mercantilism

Lots of folks think that what the economy produces is a magical product called "jobs."

That's nonsense, of course.  A capitalist economy is focused on producing goods and services, those goods and services that citizens want.  Jobs come and go; consumers rule.

One of the objections to politics that Public Choice scholars make is that politicians try to "protect" jobs at the expense of consumers / citizens.  So where the old mercantilists tried to hoard metal specie, modern mercantilists hoard jobs.  This can do great harm to citizens, the people political theorists claim a democracy SHOULD protect.  But political theorists ignore the actual incentives in the political system:  there is almost no reason to serve voters.  They are ill-informed, apathetic, and distracted. (I mean voters, not political theorists.  Though...)  Interest groups, on the other hand, are focused, tanned, and ready to help the politician out.  Serve the interest group, get reelected; serve voters, get hammered.

Examples are legion.  But a recent example here in NC is egregious that I have to admit to being surprised.  Usually some attempt is made to hide behind made up arguments.  But these guys just straight up demanded that their jobs be protected, even they themselves admit that the jobs serve no useful purpose whatsover. 

Do read the article.  Then go below the fold for some commentary.

Thursday, May 17, 2012

Rick Martinez on Amendment One in the N&O

I am sorry to have to write this post.

Let me start with some disclaimers.  First, Rick Martinez is my friend.  I don't mean the "I've met him, we've had coffee" sort of friend.  An actual friend, the sort of friend who honestly prayed that my eyesight would recover, and who is one of the most sincere, and brightest, people I know.

But Rick wrote a column yesterday, for the News and Observer here in Raleigh.  Here is the column.  I feel obliged to respond.

Wednesday, May 16, 2012

"poison the cereal"

In this clip, among other things, MWP invites my awesome neighbor, Berry Tramel, to take over coaching the Lakers:


Amar Bhide on JPM

My good friend Amar Bhide on JP Morgan.
Bloomberg video...
Too big to fail is too big.  There may be some first best world where size could be allowed.  But it is not the world we live in.

Tuesday, May 15, 2012

Teaching Penalty

The teaching penalty in higher education: Evidence from a Public ResearchUniversity
Melissa Binder et al., Economics Letters, forthcoming

Abstract:  This article investigates whether faculty members are rewarded for teaching. We find that teaching a wider variety of courses and devoting more time to teaching results in a significant wage penalty, even when research productivity is carefully controlled.

(Nod to Kevin Lewis)

The Graduation of the EYM: UNC Math B.A.


LeBron has a post on "genoenomics."

Alex T. does also.

But they missed the story.  The real answers to these questions can be found in the APSR paper written by my guys Evan Charney and Bill English.  All is revealed there.


1.  In the future, all your minor quirks will be medicalized within 15 minutes.

2.  Exports?  You can't HANDLE the exports!  Unless we pay you extra, apparently.

3.  No controlling legal authority.  Bizarrely, it takes the FEC to point out that the money given to John Edwards and spent entirely on a coverup of the mistress is NOT a campaign contribution.  This is what happens when you try to regulate campaign finance broadly.

4.  Re John Edwards:  I have written on the campaign finance problem before.  Citizens United just made the problem even more strange.

5.  This seems insane.  Hard to imagine a bank turning down an account from a successful business.  And it's likely exaggerated.  But....rare wood?  Really?

6.  Yes, really.  At least on the Gibson Guitar part of the story.  The feds cannot tell Gibson how, or even if, they broke the law.  But in the meantime the feds broke into the factory, shut it down, and confiscated the product.  "We'll get back to you."

7.  Why does France have so many firms with 49 employees?  Does anyone think this might be a problem for growth?

(thanks to the Blonde and to Angry Alex)

Monday, May 14, 2012

Atlas Pooped: A love story

"You should never feel guilty about your abilities. Including your ability to repeatedly peg a fellow toddler with your Elmo ball as he sobs for mercy"

Full story here, and it's terrific.

Euro woes

Some European financial news for you this Monday.

A Euro-wide stock index is down around 2%, The Greek stock index is down around 5%, Spain's down around 2.5%.

Spanish 10 year bonds are up to yielding 6.22%, Italy's now yield 5.75%.

German 10 year bonds are paying 1.45%, but the German and French stock indices are both down around 2%.

The big, big question is, can the Euro-zone limit contagion from a Greek exit and keep Spain and Italy in?

Sunday, May 13, 2012

Shine on you crazy Dimon

JP Morgan has taken a $2 billion loss on derivatives trading. As I've tweeted, that's around .1% of their assets and 1% of their equity, so on the surface it's hard to see what the fuss is about.

Over at Bloomberg, I found a clue:

It’s not often that a huge company calls an emergency teleconference on short notice to discuss an intra-quarter trading loss that’s equivalent to only 1 percent of shareholder equity. So when a Deutsche Bank AG stock analyst named Matt O’Connor asked Dimon why the company had disclosed it at all, the answer was bound to be revealing. “It could get worse, and it’s going to go on for a little bit unfortunately,” Dimon replied. The meaning was clear. Worse could mean disastrous.

So maybe the $2 billion is just the tip of the iceberg? Still it would have to be a very big iceberg to cause much worry about systemic risk and taxpayer involvement, wouldn't it? Maybe it is a very very big iceberg. That would be bad.

The other open question is what exactly were they doing, hedging or betting?

A classic hedge involves taking a position in the derivatives market that is opposite to your position in the "real world" to achieve certainty about future costs or revenues. If you are hedging to avoid a decline in price of an asset you own, and the price of that asset goes up, you will in all likelihood suffer a loss in the derivative that offsets the gain in the "real world". It's unlikely, though that JP Morgan would report such an outcome as an overall loss.

Even if you set up your hedge correctly, if the correlation between the "real world" asset and the derivative asset is not perfectly predictable, you can suffer an overall loss in your hedge. This is basis risk.

Maybe that is what JP Morgan is reporting; a good hedge gone bad due to basis risk.

My man at Bloomberg doesn't think so though:

Here’s what little Dimon said of the trades in question: “The synthetic credit portfolio was a strategy to hedge the firm’s overall credit exposure, which is our largest risk overall in this stressed credit environment. We’re reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective as an economic hedge than we thought.” 

There is a tantalizing clue in this language. Read the statement carefully and you can see this wasn’t a bona fide hedge. That means it probably was no different, in substance, than a speculative wager. The definition of an “economic hedge,” literally, is an investment that doesn’t qualify for hedge accounting, meaning its effectiveness at offsetting a given risk isn’t sufficiently reliable. Otherwise the wiggle word “economic” wouldn’t be needed.

This made me happy, as I learned a new term, "economic hedge" that apparently can be a synonym for "shitty hedge" or used as a fig leaf for a speculative bet.

In general, I think we want banks and businesses to hedge risk. Structured finance is not an unmitigated bad. And I think we need to recognize that even a well-executed hedge can produce losses, so we can't judge the quality of a hedge purely by its ex-post outcome. On the other hand, in this environment, banks and firms have incentives to misrepresent failed speculation as a problematic hedge and regulators need to be sensitive to that.

The question is whether it's possible to write a rule that distinguishes clean hedges from "economic hedges", especially when you realize that for many real world assets a clean hedging instrument may not even exist.

If it's not possible (and I don't think it is), then should we make banks pay for insurance against the creation of systemic risk? If so, isn't pricing that insurance going to have the same issues as writing the rule?

Or maybe we should put size caps on banks so that one bank's behavior, no matter how shitty, cannot cause systemic risk. But does it matter for systemic risk if one big bank makes bad "economic hedges" or 3 smaller banks each make the same bad bets?

I just don't see a simple rule or magic bullet that gets us out of harms way that doesn't also throw the structured finance baby out with the "economic hedge" bathwater.