Thursday, October 23, 2008


This article by Peter Leeson:
An-arrgh-chy: The Law and Economics of Pirate Organization
This paper investigates the internal governance institutions of violent criminal enterprise by examining the law, economics, and organization of pirates. To sectively organize their banditry, pirates required mechanisms to prevent internal predation, minimize crew conflict, and maximize piratical profit. I argue that pirates devised two institutions for this purpose. First, I analyze the system of piratical checks and balances that crews used to constrain captain predation. Second, I examine how pirates used democratic constitutions to minimize contact and create piratical law and order. Remarkably, pirates adopted both of these institutions before the United States or England. Pirate governance created sufficient order and cooperation to make pirates one of the most sophisticated and successful criminal organizations in history.

Unfortunately (emphasis mine),

Over the last decade or so there has been a resurgence of piracy off
the horn of Africa and in the Straits of Malacca ... Like seventeenth-
and eighteenth-century pirates, the modern variety choose to
plunder ships in waters in which government enforcement is weak, such
as those around Somalia and Indonesia, and commercial vessels are

Beyond this, however, modern pirates share little in common with
their predecessors. Seventeenth- and eighteenth-century pirates lived
together for long periods of time at sea. ... Because of this, their ships
formed miniature “floating societies.” Like all societies, pirates’ floating
ones also required social rules and governance institutions if pirates
were to maintain their “abominable combination.”

In contrast, modern pirates spend almost no time together on their
ships. Their “raids” take one of two forms. The first and most common
method constitutes little more than maritime muggery. Pirate “crews”
of two to six hop in small speedboats with guns; pull alongside legitimate
ships, usually in territorial waters close to the coast; and threaten their
prey at gunpoint to give up their watches, jewelry, and whatever money
the boat may be carrying. They then return to their villages on the coast,
where they live among nonpirates and resume regular employment.

These pirates do not live, sleep, and interact together on their ships
for months, weeks, or even days on end. They therefore do not constitute
a society and face few, if any, of the problems of social cooperation and
order their forefathers did.

The second and far less common method of modern piracy is somewhat
different. Crews again are small—between five and 15 men—and
spend very little time together at sea. But professional land-based criminals
hire these modern pirates to steal boats, which they then convert
into “phantom ships” and resell. They pay these modern pirates lump
sums and contract them on a case-by-case basis. Like the maritime muggers,
pirates-for-hire rely predominantly on hijacking methods to steal
ships, though for larger vessels they have been known to plant “insiders”—
sailors who pretend to be legitimate sailors seeking employment
on the ship in question—who later hijack the target from the inside.

Since modern pirates sail in very small groups and spend very little
time together at sea, ... that they do not require rules for creating order,
rationing provisions, or assigning tasks. Modern pirates do not even
require captains in the usual sense. There is, of course, someone who
steers the motorboat and acts as a leader among the six or so pirates;
but he is not a captain in the way that eighteenth-century pirate, privateer,
or merchant captains were.

Even organizational problems related to the distribution of plunder
are largely absent for modern pirates. ... modern sea robbers do not
sail for extended periods with growing piles of booty. Their trips are
evening cruises. When they end, the pirates return to their day jobs.
Modern pirates-for-hire do not even confront a distribution of booty
problem to this extent. The landed thieves who employ them pay them
wages. Once the pirates have taken a prize, they hand it over to their
employer. Sadly, then, modern pirates are far less interesting from an
economic or organizational point of view than their predecessors

Contrast with NGS Malacca Strait Pirates:
... 75 percent of heisted cargoes were inside jobs involving the ship’s crew, often the captain. “That’s why most are not reported,” he said, explaining that shipping companies often write off these losses rather than suffer bad press and risk losing their insurance.

It works like this, he said. A ship broker would call him and say there’s a customer who needs diesel fuel. “I know a crewman on a tanker,” Jhonny says. “I call his hand phone and ask him if he is happy. If he says yes, no problem. But if he says no, I tell him I make him happy, and then we make a plan.” But the crewman won’t work legitimately again, I said. He laughed. “Seamen have lots of names. Some have three or four passports. No problem.”

... I asked Beach Boy why he had become a pirate. “I can’t get work,” he said. Jhonny explained that Indonesian sailors often lacked the maritime certifications required to work on commercial ships. For years, young men like Beach Boy relied on older seamen to teach them the trade and then obtained counterfeit credentials to avoid the expensive training needed to become legally licensed seamen. But in recent years the international shipping community had clamped down on such practices, leaving many experienced Batam sailors unemployed.

Wednesday, October 22, 2008

What I've been reading

1. Unknown Terrorist by Richard Flanagan. This was an interesting commentary on the state of society when confronted with an external threat - in this case domestic terrorism. The notion that masses will behave like a paranoid herd, or in some cases will band together in the face of an external threat is not new. What is interesting is that this post 9/11 book is one look at society's reaction to this threat and it is not an entirely pleasant look. Few stop to question the authorities (the story is set in Sydney) and are ready to convict based on media coverage. The plot line was a little thin but Flanagan is a good enough writer that I was willing to overlook it.

2. Body of Lies by David Ignatius. Prompted by the trailers of the movie version. Unfortunately, I wanted to like David Ignatius but found the prose a little too monotonous. This might well be the only Ignatius book I'll read. The plot was predictable for me and the movie version looks to be slightly better.

3. Market Forces by Richard Morgan. Mad Max in a suit driving expensive European made cars battle it out on the roads for market dominance in the mercenary business. The first couple of chapters I almost laughed out loud but was eventually drawn into the book which is a good read and moves at a good pace. There's something about the mindless violence in Richard Morgan's books that makes me wonder about him. If this book were made into a move, I'd say Colin Farrell should play Chris Faulkner.

Wednesday, October 15, 2008

Are we out of the crisis?

It's too early to say but I happened to be reading Financial Crisis and the Great Depression: A Regime Switching Approach by Patrick Coe and it had some interesting parallels to the current financial crisis.

During 1932 there were two major policy initiatives aimed at alleviating the financial crisis, although neither appears to have had the desired effect. The first was the introduction of the Reconstruction Finance Corporation (RFC) in January 1932 to provide loans to illiquid banks. However, Mason (1996) argues that by overcollateralizing these loans, the RFC actually created a liquidity problem for the very banks it was trying to help. The second response was the Federal Reserve's open market purchases, which began in April 1932, but were abandoned in July of that year. Epstien and Ferguson (1984) argue that this program was abandoned due to pressure from member banks. As banks were substituting away from loans and into short-term government securities the Fed's open market purchases had an adverse effect on their profitability. As a result they became increasingly opposed to the program.

At midnight on March 6th, 1933, the newly inaugurated President Roosevelt declared that there would be a bank holiday from the 6th to the 9th of March. On the 9th of March, Congress passed the Emergency Banking Act (EBA) which was the first of many banking and monetary reforms contained in the New Deal. The EBA gave the RFC power to invest equity in banks without taking collateral, thus solving the problem Mason discusses. The EBA also facilitated the reopening of national banks. Roosevelt promised the public that only "sound" banks would be granted licenses to reopen. These reforms, the program for reopening the banks, and Roosevelt's "fireside chats" were intended to stabilize the financial system. The traditional view emphasizes the success of these measures in restoring stability to the financial sector.

Friedman and Schwartz argue that by restoring confidence in the monetary and economic system the EBA contributed to recovery from the depression. However, they also argue that the introduction of the Federal Deposit Insurance Corporation (FDIC) was the structural change that did the most to restore stability. This occurred in January 1934.

Recall, the RFC was what some commentators wanted to use as a model to buy up the toxic securities in the current crisis. (See here and here for instance.)

Using a Markov switching approach to calculate conditional probability of being in a crisis Coe finds:

Here it is interesting to note that two attempts to alleviate the financial crisis during early 1932, the establishment of the RFC and the open market operations, have no effect on these conditional probabilities.

Perhaps the most interesting feature ... is the implication they have for the ending of the financial crisis. If the reforms discussed in the previous section did have a positive effect on the financial system, this should be reflected in the time series of estimated conditional probabilities over the current state of the financial system. Given that the early 1930s is a period of financial crisis, one would expect the crisis to end in 1933 or 1934. Some combination of the traditional view and Wigmore's view suggests that there would be a regime change in the spring of 1933. On the other hand, the view that the introduction of the FDIC ended the financial crisis dates the regime change as being in early 1934. ... [There is] a fall in the conditional probability of financial crisis to 0.15 in May 1933. However, this is temporary. For the majority of 1933 the probability of financial crisis remains above 0.8, suggesting no change in regime immediately following the reforms of the Spring of 1933. This point is emphasized by looking at the updated probabilities .... This updated probability of financial crisis for May 1933 is 0.88. In fact, for the whole of 1933 it is never below 0.78. This suggests that while the reforms contained in the EBA and the abandonment of the gold standard may have been necessary, they were not sufficient to end to the financial crisis.

The conditional probabilities suggest that the financial crisis ends in February of 1934. This is immediately after the introduction of the FDIC in the previous month and the sharp increase in authorized lending by the RFC in December 1933 and January 1934. This is shown more clearly in the updated probabilities ... a probability of financial crisis of 0.301 in February 1934. This falls to 0.266 in March and is zero for the remainder of 1934. This result is consistent with the view that at least one of the introduction of the FDIC and the increased lending by the RFC was crucial for ending the financial crisis.

So are we in for a relative calm now that the Fed has essentially guaranteed the interbank market and taken (some) small equity stake in the banks? Remains to be seen.

Update: It would be interesting to redo this kind of analysis with some more recent indicators.

Interesting vacation spot?

Baarle-Hertog: Baarle-Hertog borders the Netherlands – but, because of its unique history of political division, the town is sort of marbled with competing national loyalties. In other words, pockets of the town are Dutch; most of the town is Belgian. You can thus wander from country to country on an afternoon stroll, as if island-hopping between sovereignties.

Being in a bit of a rush at the moment, I'll simply have to quote

Baarle-Hertog is noted for its complicated borders with Baarle-Nassau in the Netherlands. In total it consists of 24 separate pieces of land. Apart from the main piece (called Zondereigen) located north of the Belgian town of Merksplas, there are twenty Belgian exclaves in the Netherlands and three other pieces on the Dutch-Belgian border. There are also seven Dutch exclaves within the Belgian exclaves. Six of them are located in the largest one and a seventh in the second-largest one. An eighth Dutch exclave lies in Zondereigen.The border is so complicated that there are some houses that are divided between the two countries. There was a time when according to Dutch laws restaurants had to close earlier. For some restaurants on the border it meant that the clients simply had to change their tables to the Belgian side.

Sarah Laitner, at the
Financial Times, adds that "women are able to choose the nationality of their child depending on the location of the room in which they give birth."

Development in China's (interior) cities

From Peter Hessler on cities (Qiaotou, Wuyi, etc.) in Wenzhou that are not so close to the coast - actually about 100 miles.

All told, they had mapped out a 21,500-square-foot (2,000 square meters) factory, from bottom to top, in one hour and four minutes. Boss Gao handed the scrap of paper to the contractor. The man asked when they wanted the estimate.
"How about this afternoon?"
The contractor looked at his watch. It was 3:48 p.m.
"I can't do it that fast!"
"Well, then tell me early in the morning."

... Wenzhou had the priceless capital of native instinct. Families opened tiny workshops, often with fewer than a dozen workers, and they produced simple goods. Over time, workshops blossomed into full-scale factories, and Wenzhou came to dominate certain low-tech industries. Today, one-quarter of all shoes bought in China come from Wenzhou. The city makes 70 percent of the world's cigarette lighters.
...Qiaotou's population is only 64,000, but 380 local factories produce more than 70 percent of the buttons for clothes made in China. In Wuyi, I asked some bystanders what the local product was. A man reached into his pocket and pulled out three playing cards—queens, all of them. The city manufactures more than one billion decks a year. Datang township makes one-third of the world's socks. Songxia produces 350 million umbrellas every year. Table tennis paddles come from Shangguan; Fenshui turns out pens; Xiaxie does jungle gyms. Forty percent of the world's neckties are made in Shengzhou.

... That's one weakness of the Wenzhou Model. Entrepreneurs produce goods that require little capital and low technology, which makes it easy for neighbors to jump in. Boss Wang, the uncle, had slipped into the same pattern. Previously, he had manufactured the steel underwire for women's brassieres, and his profits had dropped steadily. When the two men joined forces, they decided to continue manufacturing underwire, but their goal was to find a more profitable main product.

Fortunately, the average bra is composed of 12 separate components. In a figurative sense, the men began their quest at the bottom, with the underwire, and worked their way up. They thought about thread; they looked at lace; they considered the clasp. But when they reached the top, where tiny 0- and 8-shaped rings adjust the bra straps, they found what they were looking for.

A bra ring consists of steel coated with high-gloss nylon, requiring a specialized manufacturing process. The key equipment is a computer-regulated assembly line, divided into three separate stages, each of which heats the object to over 500 degrees Celsius (930 F). Originally, Europeans produced the rings, but by the early 1990s Taiwan dominated the market. In the middle of that decade, a mainland Chinese company called Daming imported an assembly line.

After its arrival on the mainland, where production costs are much cheaper, "the Machine" essentially minted money. The boss got rich, and then a worker named Liu Hongwei got an idea. Despite his lack of formal education, Liu was a skilled mechanic, who worked closely with the Machine. Meticulously, he memorized the assembly line, piece by piece, and in secret he sketched out blueprints. When the plans were complete, he contacted a second boss at a company called Shangang Keji, in the city of Shantou.

In 1998, Boss Number Two hired Liu and took the blueprints to Qingsui Machinery Manufacture Company, in Guangzhou, which custom-built the assembly line. Initially, the new Machine didn't work—nobody's memory is perfect, after all—but two months of adjustments solved the problems. Shangang Keji began producing bra rings, but then Liu found Boss Number Three, at a company called Jinde. Every time Liu jumped, he demanded money for his blueprints and expertise; some believe he made as much as $20,000.

Without knowing it, the man was following a path blazed by other societies that had also experienced sudden manufacturing booms. In 1810, a wealthy American named Francis Cabot Lowell traveled to England, where he used his connections to tour the world's premier textile mills. British law forbade the export of machinery or blueprints, but Lowell had an excellent memory. He returned to the United States, where, in the words of his business partner, he re-invented the Cartwright loom. Lowell became an American hero, with a Massachusetts factory town named in his honor.

... New apartment complexes were rising all around Lishui, and one of the biggest was the Jiangbin development. Formerly, the 16.5 acres (6.7 hectares) had belonged to the village of Xiahe, but in 2000 the city government bought the land-use rights for one million dollars. Three years later, Lishui flipped the land to Yintai Real Estate for 37 million dollars. Given that corruption is endemic in Chinese real estate, the actual price may have been even higher.

In such an environment, everybody gambles on growth. Most of the city's massive investment in infrastructure had been borrowed from state-owned banks, which also loaned money to the developers—Yintai had borrowed over 28 million dollars for its Jiangbin venture. If the real estate market went cold, the whole system was in trouble, and the central government had recently instituted new laws intended to slow down such expansions. But the money kept pouring in—during the past five years, the average price of a Lishui apartment had risen sixfold.

On paper, it looked untenable, but the Chinese economic and social environment is unlike anything else in the world. Real estate laws are skewed in the government's favor, and migration and the export economy create a constant demand for expanding cities. After the hard times of the 20th century, the average citizen is willing to tolerate unfairness as long as his living standard improves. In Jiangbin, I met Zhang Qiaoping, whose family had formerly farmed one-third of an acre (0.13 hectare) on the site. The government paid him $15,000 for a plot of land that was worth at least $200,000. Zhang wasn't happy, but he hadn't protested; instead, he invested in a small shop next to the site. Most customers were construction workers. There wasn't much money trickling down to the lowest levels, but Zhang had tapped into enough to support his family.

Some peasants even made it to the top. Yintai is owned by the Ji family, whose patriarch had been a farmer before engaging in small-scale construction work in the 1980s. Eventually, he expanded into real estate, and now his three sons help manage the company. ...

A lot more within the link.

IMF Loans and TB

I had been sitting on these for a while now: Study links rise in tuberculosis in post-communist countries to IMF loans. (See also SciAm.) The discussion within the forum is farily interesting as well. My first reaction was similar to Steve Kass but when I looked at the study I was fairly impressed. The effect sizes were large and it potentially had the implication that adding more covariates would do little to dampen the effect sizes.

1. I would have been more comfortable seeing some kind of Extreme Bounds Analysis like Levine and Renelt. It's hard not to come to the conclusion that the authors picked the specification that resulted in a large effect size otherwise.

2. I'm surprised they were not able to control for health expenditures directly. DOTs coverage, number of physicians per capita and government spending might have been affected by IMF programs but I think I'd prefer to see a direct control with health expenditure spending. (This is all part of sensitivity analysis anyway so they might as well have put it in.)

3. The problem with determining causality is that even though these indicators move in the direction that impacts TB mortality the analyst still has to separate out the effects of the IMF program and the effects without the IMF program. These countries went to the IMF because of some kind of fiscal or exchange rate crisis and even if they had not gone to the IMF it is hard to establish that the indicators would have remained unchanged. For instance, if country A decreased government expenditures it is unclear whether this can be attributed to the IMF program per se or whether it was a result of having experienced some kind of crisis. I don't think the authors did a good job establishing causality.

While they were able to make a comparison of countries with an IMF program versus those without an IMF program, the correct comparison is one of countries in crisis with an IMF program and countries in crisis without IMF program. So, if country A is in a downward trend and then has to resort to using the IMF, it is possible that some of the indicators would have been on a downward trend as well and it's hard to see how to separate out the two with a fixed effects regression. Also, the fact that there is a trend or persistence in these variables might indicate that there is some serial correlation in the errors.

4. I was also a little concerned with some of the quality of the data. I would have thought mortality would be very accurately measured but in some countries like the Czech Republic for instance (see the link to Steve Kass) there is literally no change annually which means mortality rate was identical every year. My first reaction is that some bureaucrat just entered the previous year's number for reporting purposes. But comments indicate that TB is closely monitored so I must say I'm a little perplexed because it seems like such a coincidence for the proportion of deaths to be the same every year. Then again, we have to deal with what we have for data.

5. Overall I had some doubts about the robustness of the results but I thought the findings were interesting all the same. I think it calls for deeper investigation via interactions and mediator/moderator effects. (Yes, someone please give me a grant for this!)

In any case, I sat on this for awhile thinking I could get some research out of it and here's a preliminary abstract:

Stuckler, King and Basu (2008) show that post communist countries who have been in IMF programs have experienced significantly worse tuberculosis outcomes. Their fndings are robust to inclusions of various covariates and the effect sizes large. This paper explores the relationship between IMF programs and tuberculosis mortality using longitudinal methods. Specifically, the errors from a fixed effects regression are assumed to have an autoregressive pattern over time. Once these errors are controlled the relationship between IMF programs and tuberculosis
outcomes is no longer as robust.

Note, I remain purposely vague and technical here just because I hate being wrong.

Not quite so momentuous

Did not even come as close as I had hoped.

Summaries by Felix Salmon:
1. What Treasury is doing:
A 5% cost of tier-1 capital is incredibly low, especially when there's an embedded call option. And the common-equity kicker, at 15%, is small: that makes it a maximum of $3.75 billion, for firms getting the full $25 billion. (Citi, JPM, BofA, Wells Fargo.) There's not much dilution for equityholders here, and their companies are getting lots of cheap money: no wonder shares in Citi and Bank of America are up again today, even as the broader market is down. ... There's no doubt that TARP II, in its present incarnation, is a vast improvement on TARP I. But it's still not nearly as good as the UK scheme, which was put together to inject money exactly where it would do the most good, rather than trying to set up "standardized terms" which treat each bank equally. That seems like a waste of government money to me.

2.The potential downside:
If you're running an insolvent bank, and you get a slug of equity from Treasury, your shareholders will thank you if you use that equity to take some very large risks. If they pay off and you make lots of money, then their shares are really worth something; if they fail and you lose even more money, well, there was never really any money for them to begin with anyway. ... There's no sure way to prevent such risk-taking altogether. But if you go the UK route and insist on board seats and the ouster of failed executives, it helps. That's what Treasury did with AIG, and they should do the same with the banks they're rescuing. If they don't, they're basically getting all of the downside of nationalization with none of the upside.
I'm quite sure that Paulson hates the fact that he's semi-nationalizing the banking system. But he needs to get real and accept it, rather than trying to brush it under the carpet. Otherwise he's putting hundreds of billions of taxpayer dollars at unnecessary risk.

3. Will it work?
America's banks -- and the world's, for that matter -- have had de facto unlimited access to very cheap Fed liquidity for many months now. That hasn't induced them to lend. Will this latest recapitalization do the trick? I'm far from convinced. And what's more, the demand for loans is drying up fast: do you really feel like buying a bigger house right now, or taking out a car loan? Well, businesses are in the same boat. In a recession, their ROI falls, so they borrow less.

The main reason is the Fed and Treasury huffed and puffed for too long which resulted in so much uncertainty that it has started to affect the real side of the economy.

Friday, October 10, 2008

A momentous Columbus Day weekend?

Krugman calls it a moment of truth:
What he should have proposed instead, many economists agree, was direct injection of capital into financial firms ... in return for partial ownership. When Congress modified the Paulson plan, it introduced provisions that made such a capital injection possible, but not mandatory. And until two days ago, Mr. Paulson remained resolutely opposed to doing the right thing.

But on Wednesday the British government, showing ... clear thinking that has been all too scarce..., announced a plan to provide banks with £50 billion in new capital — the equivalent, relative to the size of the economy, of a $500 billion program here — together with extensive guarantees for financial transactions between banks. And U.S. Treasury officials now say that they plan to do something similar, using the authority they didn’t want but Congress gave them anyway.

The question now is whether these moves are too little, too late. I don’t think so, but it will be very alarming if this weekend rolls by without a ... new financial rescue plan, involving not just the United States but all the major players.

Why do we need international cooperation? Because we have a globalized financial system... We’re all in this together, and need a shared solution.

Why this weekend? Because there happen to be two big meetings taking place in Washington: a meeting of top financial officials from the major advanced nations on Friday, then the annual International Monetary Fund/World Bank meeting Saturday and Sunday. If these meetings end without at least an agreement in principle on a global rescue plan ... a golden opportunity will have been missed, and the downward spiral could easily get even worse.

What should be done? The United States and Europe should just say “Yes, prime minister.” The British plan isn’t perfect, but there’s widespread agreement among economists that it offers by far the best available template for a broader rescue effort.

I'd call for something bolder:
1. The firing of Paulson.
2. The nationalization of the financial industry.

Why 1? Paulson being a member of Wall Street would never agree to 2). Any Treasury plan that bails out current managers and shareholders will not sit well and just adds to uncertainty.
Why 2? It may help decrease uncertainty. At this point, even this outcome is uncertain. It satisfies the public's desire for some kind of retribution (which I think is more important than economists and polic makers think it is):
A couple of years ago, at the height of the boom, a friend in New York publishing described to me the indignities of being a five-figure employee commuting daily from suburban New Jersey on trains packed with traders, stock brokers and hedge-fund types.

“These were the guys who, in college, I used to step over on Sunday mornings when they were lying in a pool of their own vomit,” he said. “And now they’re earning millions and millions – in bonuses alone.”

The feeling of injustice wasn’t just about money, though it was partly about being more than solidly middle class and still struggling to pay the bills, as New York writer Vince Passaro captured so well in his “Reflections on the Art of Going Broke” (“Who’ll Stop the Drain?”) in Harper’s in 1998.

It was, rather, about a sense that the wrong people had inherited the earth.

They had taken over everything. Their salaries (and bonuses in particular) had pushed real estate costs and living expenses sky-high. Their values had permeated every aspect of life. And their choices seemed to have become the only acceptable — even viable — ones possible.

In the 1970s, even in New York, it had been financially possible for a middle class family to survive if parents — even one parent — built a professional life around something other than purely making money. In the 1980s — even in the “greed is good” (which was of course meant to be a damning phrase) 1980s — it seemed respectable, honorable and, dare I say, valuable to do things other than make a lot of money. But by the late 1990s, in New York, if you weren’t in the financial industry, it was hard to survive.

And thanks to a pointer from Half Changed World, how "ordinary" people are affected.

Fragility in the modern financial system

Some opinions seem to be emerging that not only are some individual financial institutions too big to fail but some are too interconnected to fail. See here for some rambling thoughts. From the link on Krugman's opinion:
Last month, when the U.S. Treasury Department allowed Lehman Brothers to fail, I wrote that Henry Paulson ... was playing financial Russian roulette. Sure enough, there was a bullet in that chamber: Lehman’s failure caused the world financial crisis, already severe, to get much, much worse.
The consequences of Lehman’s fall were apparent within days, yet key policy players have largely wasted the past four weeks. Now they’ve reached a moment of truth: They’d better do something soon — in fact, they’d better announce a coordinated rescue plan this weekend — or the world economy may well experience its worst slump since the Great Depression.

I am less optimistic than Paul Krugman in his piece. I think we've gone over the edge. I must admit I was overly optimistic that the financial effects could be contained within that sector and now I may be overly pessimistic. I think that herding and "animal spirits" have taken over. The fall in the stock market is too large not to affect the psyche of the public. Even Gretchen Rubin (who should know that happiness is not a function of stock market indices) has been checking the stock market. The best scenario out of this: a "lost decade" not unlike Japan and the Latin American countries for the world.

Wednesday, October 8, 2008

Update on the role of aggregate uncertainty

VoxEU provides some data on aggregate uncertainty and recessions as an update to my post on how the Fed needs to reduce volatility. (Some nice charts within the link. Emphasis mine.)

One of the most striking effects of the recent credit crunch is the huge surge in stock market volatility this has generated. The uncertainty over the extent of financial damage, the identities of the next banking casualty and the unpredictability of the policy response have all led to tremendous instability. As a result the implied volatility of the S&P100 – commonly known as the index of “financial fear” - has more increased almost six-fold since August 2007. In fact since the outbreak of the Credit Crunch it has jumped to levels even greater than those witnesses after the events of the 9/11 Terrorist attacks, the Gulf Wars, the Asian Crisis of 1997 and the Russian default of 1998. ...

So why is this banking collapse and rise in uncertainty likely to be so damaging for the economy? First, the lack of credit is strangling firm’s abilities to make investments, hire workers and start R&D projects. Since these typically take several months to initiate the full force of this will only be fully felt by the beginning of 2009. Second, for the lucky few firms with access to credit the heightened uncertainty will lead them to postpone making investment and hiring decisions. It is expensive to make a hiring or investment mistake, so if conditions are unpredictable the best course of action is often to wait. Of course if every firm in the economy waits then economic activity slows down. This directly cuts back on investment and employment, two of the main drivers of economic growth. But this also has knock-on effects in depressing productivity growth. Most productivity growth comes from creative destruction – productive firms expanding and unproductive firms shrinking. Of course if every firm in the economy pauses this creative destruction temporarily freezes – productive firms do not grow and unproductive firms do not contract. This leads to a stalling productivity growth. ...

So the current situation is a perfect storm – a huge surge in uncertainty that is generating a rapid slow-down in activity, a collapse of banking preventing many of the few remaining firms and consumers that want to invest from doing so, and a shift in the political landscape locking in the damage through protectionism and anti-competitive policies.

Tuesday, October 7, 2008

The role of aggregate uncertainty in times of crisis

In times of financial crisis, aggregate uncertainty naturally increases - not just the level but the volatility. To put this more concretely, the probability of default rises and the uncertainty surrounding the consequences of default rises.

It seems to make sense then that instead of increasing the uncertainty (assuming that the Fed/Treasury can do nothing about the level of uncertainty/probability of default) they should be directing efforts at reducing the standard deviation/volatility around this uncertainty Instead of making bold moves they seem to be stumbling:
1. Uncertainty increased by allowing Lehman to fail but saving AIG. This increase in uncertainty is due to an increase in not knowing the effects of Lehman's failure but by the apparent randomness of its actions, i.e. who will they save, who will they allow to fail.
2. Uncertainty increased by the initial defeat of the Emergency Economic Stabilization Act.
3. Uncertainty increased by the very fact that the main thrust of the Emergency Economic Stabilization Act is a reverse auction of toxic securities whose value is inherently uncertain and whose success is inherently uncertain.
4. Uncertainty increases the option value of waiting - so having the commercial paper and interbank loan market and probably eventually commercial and personal loan market dry up should not be unexpected.

I ranted about some bold moves here which I think will dampen uncertainty. There will be a short period where there is increased turmoil possibly but if the authorities act decisively aggregate uncertainty will fall. Now perhaps using some dictatorial power to force nationalization of financial institutions who will not attempt to recapitalize by issuing securities does not sound so crazy after all:
The US Federal Reserve is examining the Nordic bank nationalisations of the 1990s as a possible interim solution to the US financial crisis. (emphasis mine):
While the responses varied in each Nordic country, there a was major effort to avoid the sort of "moral hazard" that has bedevilled efforts by the Fed and the Bank of England in trying to stabilise their banking systems.
Norway ensured that shareholders of insolvent lenders received nothing and the senior management was entirely purged. Two of the country's top four banks - Christiania Bank and Fokus - were seized by force majeure.

"We were determined not to get caught in the game we've seen with Bear Stearns where shareholders make money out of the rescue," said one Norwegian adviser.

"The law was amended so that we could take 100pc control of any bank where its equity had fallen below zero. Shareholders were left with nothing. It was very controversial," he said.

Stefan Ingves, governor of Sweden's Riksbank, said his country passed an act so it could seize banks where the capital adequacy ratio had fallen below 2pc. Efforts were also made to protect against "blackmail" by shareholders.

(Other opinions on nationalization includes: Megan McArdle, Dealbook, Dan La Botz.) Unfortunately, with a Wall Street Man in charge it is unlikely that nationalization will occur and even less likely now that another Goldman Sachs alumni is in charge of the reverse auction. What was their pitch? We got you into this mess and we can get you out of it?

I think they need to act quicky to reduce aggregate uncertainty - not the piecemeal covert nationalization that has been done so far. Unfortunately, we may be too late - I fear that with contagion to Europe, we may indeed have arrived at the end of the world. As losses in the financial industry mount and affects the stock markets and hence retirement accounts, the fear can spread easily from the financial to the real sector. A crisis that could have been contained will then become out of control as herding takes over and households stop spending, saving, and earning. (Yes, I realize that having all three happen at the same time is not quite possible - but really?)

Meanwhile it looks like BoA is attempting to recapitalize:
Charlotte, North Carolina-based Bank of America said it was cutting its quarterly payout to 32 cents a share from 64 cents, which will add more than $1.4 billion in capital per quarter.
In addition, it aims to sell $10 billion in new common stock and could sell more based on demand, the bank's executives said on a conference call.

And in Britain:
According to a BBC report, RBS, Lloyds and Barclays estimate they may need 15 billion pounds ($26 billion) each to help them get through the crisis, which began in the United States last year when mortgages holders defaulted on payments. JP Morgan analysts calculated last week that major British banks had a total capital shortfall of 46 billion pounds using the Basel II capital adequacy standard.

"I think what this signals to me is that this isn't a situation where banks can muddle through," said Simon Pryke, head of global research at Newton Asset Management. "They're going to have to be recapitalized and they're going to be heavily dependent on government and the authorities for sources of funding."

Bank officials were keen to dismiss suggestions they had asked for money.

U.K. Government Considers Part-Nationalization of Banks, FT Says
U.K. Chancellor of the Exchequer Alistair Darling discussed last night with leading bankers a plan to shore up the banks by channelling taxpayers' money into them, in effect partly nationalizing them, the Financial Times reported, citing unidentified government officials.
Under the plan, the government would take stakes in banks requesting it to do so; the chancellor's team emphasized that the idea remains a contingency plan, unlikely to be put into effect this week, the newspaper said.
The meeting was also attended by Mervyn King, the governor of the Bank of England, and by Adair Turner, the chairman of the Financial Services Authority, the FT said.

Friday, October 3, 2008

Tomato farming

Fascinating article on tomatoes:
A nearly two-story-tall mechanical harvester run by the Morning Star tomato-processing company clatters through the Sacramento Valley field. As the machine hums along at about three miles per hour, it uproots two rows of plants and lays them on a belt that conveys them to the top of the harvester, where the vines are sucked through a shredder and blown back onto the field as the tomatoes cascade onto other belts. Electronic eyes send signals to plastic fingers that pop out anything not red or green. Dirt clods, last year's squash and the errant toad and mouse tumble to the ground. The ripe fruit is funneled into a tandem trailer. In ten minutes, the machine gathers more than 22,000 pounds of Roma-type processing tomatoes.

I get into a pickup truck with Cameron Tattam, a Morning Star supervisor, and we follow a semitractor that hooks up to the trailer, pulls out of the field and then barrels down Interstate 5 to a Morning Star cannery outside the town of Williams. This 120-acre facility is the largest of its type in the world. During the three months of the local harvest, it handles more than 1.2 million pounds of tomatoes every hour. The tomatoes I just saw getting picked are washed down a stainless steel flume and plunged into a 210-degree cooker. The heat and pressure blow them apart. After passing through evaporators and cooling pipes, they will end up three hours later as sterile-packed tomato paste in 3,000-pound boxes. For the next two weeks, the facility will produce nothing but paste that is destined to become Heinz ketchup. Among Morning Star's other large customers are Pizza Hut, Campbell's Soup and Unilever, maker of Ragu.

And an interesting titbit:
The tomato itself is a seed-bearing fruit, but the Supreme Court, noting its customary place in the meal, classified it as a vegetable in 1893, for the purpose of deciding which tariff to charge for imports.

Thursday, October 2, 2008

Some scrutiny of credit ratings agencies?

In this post which was rather long winded, I had said that the role of credit ratings agencies in the current crisis should deserve some scrutiny. Angry Bear rails:
What is the point of pooling pools of mortgage bonds and making new tranches ? Much money was made by taking the middling seniority tranches of pools of mortgage bonds and reslicing them to make senior (AAA) tranches and equity tranches. Was there really any more diversification to be done ? Or was this a way to game the bond ratings ?

In Reason (ht: Marginal Revolution)
... housing markets being local, so that the assets in the pooled security didn't move together. ... a firm could build highly rated investment portfolios of purportedly uncorrelated assets out of nothing but mortgages from different parts of the country. Once these portfolios were built, it would become easier to finance houses even for buyers of dubious credit. The problem was that these new securities, and the money which flowed into all housing markets, were sufficient to generate correlation in housing values across the country. As everyone followed the experts' advice—and invested in these new mortgage-backed assets—we began to observe correlated behavior in the housing market, nationwide.

So how did the securities maintain their high investment grades? Once correlations were evident, once the interconnectedness of housing markets nationwide was evident, why didn't another set of experts, the rating agencies, step in and downgrade the securities?

Because of incentives, the cornerstone of economists' advice about how to get good economic outcomes. In this case, the incentives weren't there to obtaining unbiased estimates of security values. Instead, incentives favored "rating shopping" and so, unsurprisingly, rating shopping became the norm. The Securities and Exchange Commission's 1994 report, Concept Release:
The Nationally Recognized Statistical Ratings Organization (NRSRO), contained the following sentences:"A mortgage related security must, among other things, be rated in one of the two highest rating categories by at least one NRSRO." The phrase "one of the two highest rating categories" authorized the firm holding a mortgage backed security to shop for ratings. If one rating agency failed to produce a desirable rating, the firm could look for another, more favorable rating.

Those who made the ratings became like expert witnesses in court, seeing things the way their clients, the firms holding the securities and offering them for sale to you and me, wanted things to be seen. The problem was that shoppers, like a jury, did not have the ability to average out different pieces of testimony to help remove the bias. As long as experts were trusted and the market didn't know the difference between unbiased and biased estimates, the trick worked marvelously. The collapse followed suddenly as we have all come to understand that the ratings were miserably biased.

Update (from Angry Bear):
... limit on fees makes it possible for fees to be so low that credit issuers obtain ratings from all reputable agencies. It can also mean that an excellent reputation is not worth more than an average reputation. ... that implicit collusion can be maintained. That is, there is an equilibrium in which both agencies give generous ratings to new instruments and both damage their reputations when the crash comes. ... in this equilibrium, they rate sludge AAA. Then the crash comes and -- so what. They all have roughly equal amounts of egg on their faces. We can't do without credit rating agencies.

Not more anecdotes!

Small Businesses Feeling the Chill:
Some small companies say they are no longer able to get loans from newly cautious banks as credit tightens across the country, and even those who do qualify are increasingly reluctant to borrow and expand, fearful of overextending themselves in the midst of the financial crisis. ...
Even with the current turmoil in the credit markets, big established businesses generally have far greater access to credit than their smaller cousins. For borrowing, small businesses often rely on banks, credit cards and small-business loans. Big businesses have substantial bank lines of credit that they can draw down as needed if they have trouble issuing new debt, usually a less expensive option. While the markets remain cool to financial companies and those with any hint of debt problems, many corporations have been able to sustain their financing, often by selling commercial paper, a form of short-term financing, albeit at higher rates than a month ago....

This article would be worrying if it weren't so anecdotal. Several issues here that are not being fleshed out:
1. We should expect to see some tightening of lending standards since it was lax lending that got us into the current mess in the first place.
2. We should also see some businesses that are less willing to borrow and lend given that aggregate uncertainty has increased. (Option value of waiting, blah, blah, blah.)
3. Given that aggregate uncertainty has increased, some firms that may have been considered healthy once in boom times may now be considered marginal e.g. they may have expanded too quickly during the boom and are now vulnerable to a downturn.
3. We want to know this: Given the level of uncertainty, are there more firms than what we would expect who want and qualify for loans who cannot get them. This assumes that we know what the average should be, which means that we can identify the underlying fundamentals for total loans in the economy.

Update from Cato Institute (October 5, 2008) - so I'd take it with some salt:
In August, bank loans to consumers were 9.5% higher than they were a year earlier--the fastest increase since 2004. The year-to-year increase in consumer and industrial loans was 15.5%, down only slightly from a recent record high of 21.6% in March. Real estate loans were up 4.1% for the 12-month period ending this August--flat lately, but not down.

Did bank lending suddenly turn south since August? The latest data is for the week ending Sept.17, when the U.S. expropriated 80% of AIG (nyse: AIG - news - people ) equity and thus tanked most financial stocks. U.S. bank credit hit a record of over $7 trillion in the latest week--up from $6.57 trillion a year earlier and $6.92 trillion at the end of July.

Contrary to many comments, consumer and industrial loans actually increased in the latest week. Troubled giant banks have cut back on lending, but smaller banks have picked up the slack. Consumer and real estate loans dipped insignificantly through Sept. 17, remaining much higher than they were a year earlier.

If all the recent hysterical chatter about lending being "frozen" or "shut down" refers to anything real, it is not about banks loans (through Sept. 17) but about such arcane financial markets as asset-backed commercial paper or loans between banks. But this too is mainly about financial firms, not Main Street. Non-financial commercial paper increased from $156 billion at the start of the year to more than $204 billion from Sept. 3 to Sept. 17, dipping only modestly since then.

Economic journalists seem oddly fascinated with the last column of the table--interbank loans from one to another (aside from fed funds). "Banks won't even lend to each other," said a TV reporter, "so how can we expect them to loan to business or consumers?" But interbank loans are obviously tiny, and banks rightly regard lending to other banks more risky than lending to Main Street. There is no reason to expect the minuscule flow of interbank loans to determine consumer and business loans. That little tail can't wag the big dog.

The table referred to is Assets and Liabilities of Commercial Banks in the United States

Update (October 7, 2008):
Here's the evidence that there is some credit problems - the commercial paper affects large companies - so, yes, if they are unable to have cash for day to day operations, I would be worried.
The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.

Mark to market round up

In an earlier post, there had been suggestions of suspending mark-to-market. Here's a round up of the views thanks to EV. The criticisms of mark-to-market generally seem to follow this line of argument:

We don't know when we're in a bubble so when prices go up we should not suspend mark-to-market. (Fair argument. I'll accept that mark-to-market should not be suspended given we don't know whether we're in a bubble.) The argument also holds in reverse. We should not suspend MTM because we don't know what fair value is in a crisis, so the fair value of the market is the market price. After all markets are rational and reflect all information and is embedded in the prices. Contrary to not knowing when we're in a bubble, I think we know when we're in a crisis. So I reject this argument.

Yes, suspending MTM sets a precedence to the extent that whenever prices fall just a little there will be some lobbying for suspension. But what is the alternative to MTM? I realize that valuing securities is a very different from valuing privately held firms. I work at a privately held firm that is employee owned. Should I not believe the valuations of the accountants just because its stock is not publicly traded? Yes, accountants have been tarnished because of Enron so perhaps the alternative to valuing securities by private accountants should be dispensed with and government accountants might be held in higher esteem. Imagine that - we can actually hold government employees in high regard!

Note that we are not saying that MTM caused the crisis. It is a side effect that can be treated. It won't lead to a cure. For instance, if you have been infected by a virus and have a high fever, do you not treat the fever and let the virus run its course? The argument that is being held by the skeptics is to not treat the symptom (fever) which may make recovery even longer (or at the most more uncomfortable).

The hypocritical calls for not suspending MTM is a belief in markets. If these naysayers are such strong believers in the market process then are these the same people in the financial industry that are crying for a bailout? If they really believe in the free market process then they should believe that the financial industry should be left to battle the ravages of the disease that it spawned with no outside intervention until the disease has run its course. If they believe that the market process is so superior shouldn't they also believe that the destruction that this process has wrought will leave us in a stronger and more resilient if there is no intervention?

I will only quote those who are on my side since I'm feeling particularly partisan today:
Justin Fox: Suspending Mark to Market is for Zombies:
Mark-to-market had its roots in the efficient-market revolution in finance in the 1960s--whose adherents believed that the prices prevailing in the stock market and other financial markets were near-perfect reflections of economic reality. Such thinking soon prevailed in academic accounting circles as well, and the accounting professors began pushing for accounting standards that fit with their new worldview.

The savings and loan mess of the 1980s, which became such a big mess in large part because S&Ls didn't mark their assets and liabilities to market, provided real-world impetus for such a shift. Most S&Ls became insolvent in the early 1980s because of the mismatch between the double-digit interest rates they had to pay to borrow money and the 5% to 6% a year they were earning on the 30-year-fixed mortgages that made up the bulk of their assets. But the accounting standards of the day obscured this grim reality. Some S&Ls--like Washington Mutual--took advantage of the reprieve to trim down, shape up and get themselves out of trouble. Many others became what's known as zombie banks, lurching across the landscape running up ever bigger losses until taxpayers had to put up several hundred billion dollars to shut them down and pay off insured depositors. ...

So in December 1991, the
FASB decreed (pdf!) that there should be fair-value accounting for financial instruments. And lo there was fair value accounting for financial instruments! While there have been lots of debates through the years over the particulars of how to implement it, the basic idea had in recent years ceased to be very controversial. The lack of fair-value accounting in Japan and the resulting scourge of zombie companies were often cited, in fact, as key causes of the country's economic stagnation in the 1990s. (By the way, Japanese accounting authorities finally began moving toward mark-to-market last year.)

Earlier this year, though, complaints that mark-to-market was worsening the financial crisis began to surface. Blackstone's Steve Schwarzman was
among the most prominent critics. And while much of this talk was self-interested hooey (why wasn't Schwarzman complaining about mark-to-market in 2006?), there was also an important intellectual shift at work. ...

But today I was talking to Gene Flood, a former Stanford finance professor who now runs the fixed-income money manager
Smith Breeden Associates, and he surprised me by saying that he is no longer quite the fervent believer in mark-to-market that he once was. "The credit crisis has caused such a liquidity crunch that market prices are not a good reflection of true economic value," he said. "If you are forced to mark everything to market, then you are not getting a good economic picture of the economic health of the institution."

Flood doesn't want to suspend mark-to-market accounting. He just agrees with the new FASB/SEC directions for companies to pay less heed to prices coming out of clearly distressed markets. Paul Miller doesn't have a big problem with this guidance either.

Which leads me to the following conclusions.
First, as
commenter That Anonymous Dude puts it, "MTM is the worst form of accounting, except for all those other forms that have been tried from time to time."
Second, investors and regulators and reporters and corporate executives need to learn not to take any financial reporting numbers, whether marked-to-market or not, at face value. The health of a bank or any corporation can never be adequately measured by a single bottom-line number. Understanding the assumptions and uncertainties inherent in accounting numbers is crucial to understanding how to use them.

A contrarian view - my comment is to agree up to a point. MTM works in a highly liquid market and yes, I would be suspicious of any company that does not MTM its securities when a market exists. So MTM should not be suspended wholesale but perhaps only in the CDS and CDO market which are OTC where liquidity has dried up.