Sunday, May 23, 2010

A financial blog post round up

A round up of some blog posts I had been sitting on and racking my brains on how to intelligently discuss them but unable to come up with anything so I thought I'd just list them here with some short comments:
1. I had previously wondered whether the U.S. would experience a lost decade here and here and Krugman asserts that this is a looming possibility:

Recent data don’t suggest that America is heading for a Greece-style collapse of investor confidence. Instead, they suggest that we may be heading for a Japan-style lost decade, trapped in a prolonged era of high unemployment and slow growth.

Tim Duy:

To summarize, the Fed believes we are facing another threat to demand, either via financial or real trade linkages, at a time when lending activity continues to fall, suggesting that monetary policy is too tight to begin with. But the Fed stance is to believe that monetary policy is on the verge of being too loose, and, if anything, planning needs to be made to tighten policy. At the same time, Fed policymakers also believe fiscal policy needs to turn toward tightening as well. Meanwhile, unemployment hovers just below 10%, nor is it expected to decline rapidly, and inflation continues to trend downward.

All of which together suggests that the Fed's policy stance is seriously out of whack with policymaker's interpretation of actual and potential economic developments. And I have trouble explaining the disconnect.

One of the things we tried to do a few months ago was to rebalance our portfolio based on what we thought the likley outcome in the next 10 years would be. Our thought was that the Fed/Treasury would try to inflate its way out of debt (somewhat) and inflation would rise. Even if it did not, the increase in debt would place upward pressure on interest rates. As such we moved most of our savings out of equities into TIPS. Where does the current commentary leave us?

As Krugman points out, interest rates have actually fallen due to the Greek crisis and the deflation is now a possible scenario (again!). While my longer term outlook for interest rates remains the same, the likelihood of this happening is decreasing - in other words, I have to revise downward my prior on the probability of inflation being likely in the medium term. Unfortunately, with the battering the equity and bond markets are taking there doesn't seem to be any safe sanctuary for our retirement savings.

2. That ratings agencies amplify crises and really have no role in regulation was something I had not thought about before:

During the boom, early rating downgrades would help to dampen euphoric expectations and reduce private short-term capital flows which have repeatedly been seen to fuel credit booms and financial vulnerability in the capital-importing countries. By contrast, if sovereign ratings had no market impact, they would be unable to smooth boom–bust cycles. Worse, if sovereign ratings lag rather than lead financial markets, but have a market impact, improving ratings would reinforce euphoric expectations and stimulate excessive capital inflows during the boom whereas during the bust, downgrading might add to panic among investors, driving money out of the country and sovereign yield spreads up. If guided by outdated crisis models, sovereign ratings would fail to provide early warning signals ahead of a currency crisis, which again might reinforce herd behaviour by investors.

The clincher: Rather than to establish yet another rating agency, the appropriate policy response will be a thorough revision, in fact exclusion, of the role of sovereign ratings in prudential regulation and even in internal industry guidelines.

3. However, the fact that derivatives can be destabilizing is something that I had been aware of and is now part of the popular culture thanks to Michael Lewis in the Big Short. Ideally, the existence of CDS would have allowed the shorts to make markets more efficient by signalling that they thought the underlying mortgage securities were over-priced. The fact that the shorts were able to make billions by buying so many CDSs (in effect taking the opposite side of the securitization) without affecting the price of the CDOs that were being sold to investors seem to me to be a failure of information transmission - the markets aren't transparent enough. If I knew that someone was willing to take a large position on the opposite side of my transaction then this would give me pause.

Perhaps the problem is so much derivatives per se but the lack of understanding in the markets and how they are interlinked as well as largely the fact that these transactions are not transparent. Could the existence of a more liquid and transparent market in CDSs and CDOs/mortgage securities been able to prevent the bubble? Hardly - the existence of put options for S&P and other stocks have not been able to prevent a bubble and it's hard to believe that this might be a self-regulating mechanism.

4. A very articulate response from Kocherlakota on why macroeconomic models failed us. The thrust is that macro models and the act of modeling are very segmented. Labor market frictions, price frictions and financial and asset market frictions are features of some macro models and not all models. In other words, it is hard to build a coherent macro model with all the frictions in at once. A model like this would be more realistic.

However, incorporating the financial sector is extremely hard. Perhaps it is made all the more harder by the fact that economists rarely try to work together to build these models and they rarely share code. Perhaps this is because of the publish or perish mentality - that if I share my code with you, you may be able to beat me to getting published just by tweaking my code a little. I don't know how relevant this is but the fact that different economists are working on different aspects of economic frictions and not coming together to try to build a large scale model says several things:

a) They do not believe that all frictions are created equal - my friction is bigger than your friction
b) Large scale DSGE models are impossible perhaps due to computational constraints and perhaps it is somewhat related the stigma attached to large scale macroeconometric modeling that took place in the 1970s (and its subsequent failure)
c) Economists actually believe that it is better to compete amongst themselves to build better models than to cooperate to build better models.

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