global financial crash yay!

Germany and France are out of the recession (thought he Eurozone as a whole is not): http://news.bbc.co.uk/1/hi/business/8198766.stm

That Germany is out is indeed surprising, since only a few months ago many were drawing comparisons between its economic and demographic situation and Japan's (i.e. overly reliant on exports and an ageing population).

Pretty mental article in the WSJ last week. Microfinance loans may be causing credit bubbles in Indian slums: http://online.wsj.com/article/SB125012112518027581.html

Cool chart at the FT -- "Are European banks too big to fail?" -- showing total assets as a percentage of GDP, loans to deposits, and tier 1 capital ratios of all major European banks, and household debt levels for the Eurozone. Scary stuff.

Shadow banking for beginners: Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007, Gary B. Gorton.

Abstract:
The 'shadow banking system' at the heart of the current credit crisis is, in fact, a real banking system – and is vulnerable to a banking panic. Indeed, the events starting in August 2007 are a banking panic. A banking panic is a systemic event because the banking system cannot honor its obligations and is insolvent. Unlike the historical banking panics of the 19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms 'running' on other financial firms by not renewing sale and repurchase agreements (repo) or increasing the repo margin ('haircut'), forcing massive deleveraging, and resulting in the banking system being insolvent. The earlier episodes have many features in common with the current crisis, and examination of history can help understand the current situation and guide thoughts about reform of bank regulation. New regulation can facilitate the functioning of the shadow banking system, making it less vulnerable to panic.

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EDIT: Wow, this paper is fucking essential reading...

Roundtable on the state of macro at The Economist: http://www.economist.com/blogs/freeexchange/lucas_roundtable/

Structured Finance for Beginners

Another must-read: The Economics of Structured Finance, by Joshua Coval, Jakub Jurek, and Erik Stafford

Not sure why there isn't an abstract, but there you go. I think if you read this paper alongside Gorton (posted above), you can learn everything that you need to know about the financial crisis (well, almost): the shock that occurred due to the mispricing of structured credit instruments (the expected value of structured credit securities is extremely sensitive to parameter errors, specifically, small changes to default rates and correlation coefficients quickly reduce expected values, even for senior tranches -- junior tranches are often only equal in size to expected default rates -- and this sensitivity is massively increased when the collateral in the CDO includes other forms of structured credit, such as RMBS or mezz tranches of other CDO), and the mechanism by which this shock was translated to the shadow banking system (increasing haircuts in the repo markets -- effectively a run on the shadow banking system), and then to the rest of the financial system (asset prices in all classes being affected -- a systemic event).

NYT -- "Obama to Nominate Bernanke to 2nd Term at Fed"

This looks interesting

Case Closed, by Robert A. Haugen and Nardin L. Baker

Abstract:
This article provides conclusive evidence that the U.S. stock market is highly inefficient. Our results, spanning a 45 year period, indicate dramatic, consistent, and negative payoffs to measures of risk, positive payoffs to measures of current profitability, positive payoffs to measures of cheapness, positive payoffs to momentum in stock return, and negative payoffs to recent stock performance. Our comprehensive expected return factor model successfully predicts future return, out of sample, in each of the forty-five years covered by our study save one. Stunningly, the ten percent of stocks with highest expected return, in aggregate, are low risk and highly profitable, with positive trends in profitability. They are cheap relative to current earnings, cash flow, sales, and dividends. They have relatively large market capitalization and positive price momentum over the previous year. The ten percent with lowest expected return (decile 1) have exactly the opposite profile, and we find a smooth transition in the profiles as we go from 1 through 10. We split the whole 45-year time period into five sub-periods, and find that the relative profiles hold over all periods. Undeniably, the highest expected return stocks are, collectively, highly attractive; the lowest expected return stocks are very scary - results fatal to the efficient market hypothesis. While this evidence is consistent with risk loving in the cross-section, we also present strong evidence consistent with risk aversion in the market aggregate's longitudinal behavior. These behaviors cannot simultaneously exist in an efficient market.

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The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.

The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system.

One part of that cost is especially apparent just now as students return to universities. For years, much of the best young talent in the western world has gone to private financial firms. At Harvard more than a quarter of our recent graduates who have taken jobs have headed into finance. The same is true elsewhere. The extent to which employees in the US financial sector are more likely to have college educations than other workers has more than tripled over the last three decades.

At the individual level, no one can blame these graduates. But at the level of the aggregate economy, we are wasting one of our most precious resources. While some part of what they do helps to allocate our investment capital more effectively, much of their activity adds no economic value.

Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful.

The fact that they are not is itself a waste of resources. But the reason they are not – what provides the incentive that attracts so many of our best students into finance – also bears on how well our financial system is serving our economy.

In the US, both the share of all wages and salaries paid by the financial firms and those firms’ share of all profits earned have risen sharply in recent decades. In the early 1950s, the “finance” sector (not counting insurance and real estate) accounted for 3 per cent of all US wages and salaries; in the current decade that share is 7 per cent. From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent.

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http://www.ft.com/cms/s/0/2de2b29a-9271-11de-b63b-00144feabdc0.html

Wow - this looks big: This Time is Different: Eight Centuries of Financial Folly, by Carmen M. Reinhart & Kenneth Rogoff

Product Description

Throughout history, rich and poor countries alike have been lending, borrowing, crashing--and recovering--their way through an extraordinary range of financial crises. Each time, the experts have chimed, "this time is different"--claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. This book proves that premise wrong. Covering sixty-six countries across five continents, This Time Is Different presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes--from medieval currency debasements to today's subprime catastrophe. Carmen Reinhart and Kenneth Rogoff, leading economists whose work has been influential in the policy debate concerning the current financial crisis, provocatively argue that financial combustions are universal rites of passage for emerging and established market nations. The authors draw important lessons from history to show us how much--or how little--we have learned.

Using clear, sharp analysis and comprehensive data, Reinhart and Rogoff document that financial fallouts occur in clusters and strike with surprisingly consistent frequency, duration, and ferocity. They examine the patterns of currency crashes, high and hyperinflation, and government defaults on international and domestic debts--as well as the cycles in housing and equity prices, capital flows, unemployment, and government revenues around these crises. While countries do weather their financial storms, Reinhart and Rogoff prove that short memories make it all too easy for crises to recur.

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The Big Four haven't finished screwing over US taxpayers.

Recommended Reading

The Financial Crisis: An Inside View, by Phillip Swagel

This paper reviews the events associated with the credit market disruption that began in August 2007 and developed into a full-blown crisis in the fall of 2008. This is necessarily an incomplete history: the paper is being written in the months immediately after I left Treasury, where I served as Assistant Secretary for Economic Policy from December 2006 to the end of the Bush administration on January 20, 2009.

The focus here is on key decisions made at Treasury with respect to housing and financial markets policies, and on the constraints faced by decision makers at Treasury and other agencies over this period. I will focus on broad policy matters and economic decisions and not go into the financial details of transactions such as with the GSEs and AIG. A key point of emphasis is to explain constraints on the policy process—legal, political, and otherwise—that were perhaps not readily apparent to outsiders such as academic economists or financial market participants.

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"No One Saw This Coming": Understanding Financial Crisis Through Accounting Models, by Dirk J Bezemer

ABSTRACT
This paper presents evidence that accounting (or flow-of-fund) macroeconomic models helped anticipate the credit crisis and economic recession. Equilibrium models ubiquitous in mainstream policy and research did not. This study identifies core differences, traces their intellectual pedigrees, and includes case studies of both types of models. It so provides constructive recommendations on revising methods of financial stability assessment. Overall, the paper is a plea for research into the link between accounting concepts and practices and macro economic outcomes.

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The bad news, US edition

Recommended Reading

• A Tale of Two Depressions, Barry Eichengreen & Kevin H. O’Rourke

It’s a Depression alright

To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event.

That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline.

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• Housing, Global Finance, and American Hegemony: Building Conservative Politics One Brick at a Time, Herman Schwartz

Abstract

How did US housing markets articulate both with global financial flows and US domestic politics? During the long 1990s, the US economy benefited from a system of global financial arbitrage in which the US economy as a whole borrowed short term, at low interest rates, from the rest of the world, while lending back long term at higher returns. A temporarily self-sustaining housing market boom in the US based on declining nominal interest rates emerged from these flows. This boom favored employment and gross domestic product (GDP) growth in the US at the expense of some but not all advanced economies. The more that housing market financial structures in an economy approximated those in the US (wide-spread homeownership, high levels of mortgage debt to GDP, low transaction costs for mortgage refinance, and mortgage loan securitization), the better that economy performed in GDP and employment terms during the 1990s. While falling interest rates could have benefited all economies, US style housing markets proved better at translating disinflation into new aggregate demand. This situation consolidates voter preferences around a continued low inflation environment, continuation of US financial arbitrage, and maintenance of high housing prices.

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• Global financial crisis: The challenge to accounting research, Patricia J. Arnold

Abstract

Accounting practices are deeply implicated in the current financial crisis and in proposals for recapitalizing financial institutions and restoring stability to the global financial system. This essay discusses the methodological and theoretical gaps in accounting research that explain our failure to anticipate the crisis and limit our ability to analyze and respond to it.

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The 4

vimothy said:

The Big Four haven't finished screwing over US taxpayers.

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That seems to be 'for sure' and ongoing for the foreseeable - or unforseeable future ...
grrr

Hugely interesting interview by James Fallows with Gao Xiqing, head of the CIC: “Be Nice to the Countries That Lend You Money”

Scott Summer is blaming it on the Fed. Crazy-ass post up at VoxEU:

Here is a puzzle. Almost everything we have learned from recent research in monetary history, theory, and policy points to the Federal Reserve as the cause of the crash of late 2008. More specifically, an extremely tight monetary policy in the US (and perhaps Europe and Japan) seems to have sharply depressed nominal spending after July 2008. And yet it is difficult to find economists who believe this. More surprisingly, few economists are even aware that their views conflict with the standard model, circa 2009.

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Basically, monetary economic orthodoxy (which Summer claims most economists are forgetting) states that nominal interest rates are a a very poor indicator of monetary policy. For instance, the Fed heavily cut its discount rate during the Great Depression, but obviously no one would say that money was easy during that period. And in fact, the Fed has been paying banks to hold onto the money that it has been pumping into the financial system:

Even worse, most economists ignored the Fed’s 6 October 2008 decision to start paying interest on reserves – which meant the Fed bribed banks to hoard all the extra liquidity they were injecting into the system. If this sounds unfair, consider that the Fed itself indicated that these payments were necessary to prevent market interest rates from falling; an explanation that Woodward and Hall (2008) correctly described as “a confession of the contractionary effect.”

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In short,

If I am right, it was a massive intellectual failure within the economics profession, not reckless bankers, that caused the crash of 2008. This was a failure to trust our own models.

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Damn. Thoughts?

Shipping inventory overhang

Household debt, consumption and wealth, by Ilian Mihov:

It is very common these days to hear that the global economy has no way of recovering because the most powerful engine of global demand – the American consumer – is choking in debt. ...

Indeed,... debt stands at $14.068 trillion or slightly less than 100% of GDP. Does this mean that the economy is doomed? There are two points that one has to take into account when evaluating the role of household debt in the economy.

1. Debt is only one side of the story. Households also own assets. Consumption is a function of (net) wealth, not only of indebtedness. Up to a first approximation what matters is the difference between assets and liabilities. Indeed, no one thinks that a person with $10 million in debt is going to cut his or her consumption, if you know that this person has $10 billion in assets. So, how do American consumers fare in terms of net worth? Below is a graph with three ratios – assets-to-GDP, debt-to-GDP and net-worth-to-GDP. Although household debt stands at 100% of GDP, assets owned by US households currently stand at $67.2 trillion or 475% of GDP. The net worth of the American households is estimated to be over 375% of GDP.



Are these assets sufficient? This is hard to tell because theory does not provide convincing guidance as to what the wealth-to-GDP ratio should be. But we can look at the data to see how these numbers compare to historical averages. The average ratio of US household net worth from 1952Q1 to 2009Q2 is about 350% (if we exclude the two bubbles, the ratio is 330%). In short, US households today have more net wealth than they had in normal times in the post WWII period. Contrary to all complaints, US households today are richer than at any point in time in the pre-1995 period (and again, this is relative to GDP; in absolute terms no one will be surprised that this statement is true).

But maybe it is the composition of debt that matters – people today live off their credit cards. It turns out that consumer credit has increased indeed over the past 20 years but the numbers are not shocking. From about 14% in 1990, consumer credit rose to 17.3% in 2009 (again the numbers are relative to GDP). ...

2. Even if we concede that debt can reduce consumption for an individual, it is a bit trickier to make the same argument for the national economy. The reason is that the liability of one individual is an asset for someone else. In the graph above, the thin blue line is in fact included in the thick red line! ...

There are ways in which this “neutrality of debt” may break down. For example, if those who are indebted have a higher propensity to consume than the lenders, then debt will lead them to cut their consumption by more than the lenders will increase theirs (due to the wealth effect). This is possible and even plausible, but it is not clear whether empirically this effect is significant. Second, it might be that household debt is held by foreigners. Again, the data are not very supportive of this hypothesis because the net foreign asset position of the US is not (yet) devastating – less than 20% of GDP.

In general, many other “imperfections” in the market economy can result in the importance of debt for aggregate consumption, and I do agree that some of these imperfections are realistic and important. The main point of the argument is that we need a more nuanced view of why debt matters. We should keep in mind that the net worth of US households is still quite high (375% of GDP) and that debt should be viewed from a general equilibrium point of view and not only in absolute terms.