Chinese Marshalll Plan

A look at the Chinese Marshall Plan

What’s interesting to see in this story, especially the top where the Chinese leaders give American institutions a well-deserved tongue lashing, is the way the Chinese fail to see that they’ve already had the benefit of their investment in American mortgage-backed securities. In fact, the recycling of Chinese profits into American mortgage debt is beginning to look like a 21st Century Marshall plan gone awry.

By investing in the US, the Chinese primed a consumption pump that created demand for their goods. That demand absorbed the huge number of workers coming to the cities over the last decade and accelerated China’s growth. In other words, the Chinese encouraged and enabled the irresponsibility of American households because it created demand for their goods.

After World War 2, the US faced a crisis of productive over-capacity. The solution was to send a lot of money to Europe that would then be used to buy American goods. In the case of the original Marshall plan, the sorry state of post-war Europe gave the plan a humanitarian glint. But that shouldn’t mask the real value of the Marshall plan or its intent.

Flash forward fifty years and you have China eager to raise the standard of living at home. Only this time, North Americans are tapped out, not because of a devastating war but because of devasting dotcom bubble bursting. There’s no way to dress this one up as the good guys coming to the aid of their fallen cousins.

That’s a shame. I don’t know what the final accounting was on the Marshall plan loans. I’d be curious to know. But in reading these stories, I’m beginning to think the Chinese are being a little disingenuous when they keep demanding that their investment in US securities be safeguarded.

Financial flows and crisis

The Economist has an article on the link between global imbalances and the financial crisis. It brings together Rogoff, Caballero and Gournichas.

Crises, bubbles and capital inflow

Reinhart and Rogoff assess the anatomy of a financial crisis.

“Systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike”

The interest that I have is, how far is this explained by the inflow of capital from China and the commodity exporters? What I need to do is look at the evidence of capital inflow and compare this with what happened to the US, UK and others like Iceland.

Not original - but good!

Your manuscript is both good and original, but the part that is good is not original and the part that is original is not good.
- Samuel Johnson

Market evolution

Constantinides, Jackwerth and Perrakis find that index options become more efficient over time, suggesting that market can evolve towards efficiency.

Widespread violations of stochastic dominance by one-month S&P 500 index call options over 1986-2006 imply that a trader can improve expected utility by engaging in a zero-net-cost trade net of transaction costs and bid-ask spread. Although pre-crash option prices conform to the Black-Scholes-Merton model reasonably well, they are incorrectly priced if the distribution of the index return is estimated from time-series data. Substantial violations by post-crash OTM calls contradict the notion that the problem primarily lies with the left-hand tail of the index return distribution and that the smile is too steep. The decrease in violations over the post-crash period 1988-1995 is followed by a substantial increase over 1997-2006 which may be due to the lower quality of the data but, in any case, does not provide evidence that the options market is becoming more rational over time.

VIX, volatility and risk

Don Fishback looks at the VIX index and the volatility that is implied and compares the two. He finds that the market is less volatile than the index would imply. He finds that the S&P 500 is within 1 standard deviation of its daily return for 85% of the time rather than the 68% that would be suggested by a normal curve.

UK pension assets

State Street report that UK pension fund hold following assets

- 22% UK equities
- 28% overseas equities
- 33% bonds
- 7% property
- 6% altnernative assets
- 4% cash

Report from the FT which concentrates on the postive effect of sterling's fall in the value of overseas holdings.

Risk

Mark Thoma looks at risk: was it misperceived, misrepresented or misallocated?

We know that excessive risk taking was a factor in the financial crisis, but why people were willing to take on excessive risk?

There are several explanations for this. In one class of models, misperception of risk generates excessive demand for risky assets, housing and financial assets in particular. There are a variety of stories about why risk is misperceived, ratings agencies failed to do their jobs, risk assessment models turned out to be wrong, people believed that housing prices would continue to go up, and so on. The key is that in this class of models the misperception of risk gives people a false sense of security, and induces them to take on more risk than they can handle.

In another class of models, risk is misrepresented. Here, there is out and out fraud or other practices where, essentially, people know that the house is made of cards, but advertise it as being made of bricks anyway, and assure people that it is perfectly safe. Fraud could cause the victim to misperceive risk, so this is related to the first class of models, but I am trying to separate excessive risk taking brought about by intentional misrepresentation from excessive risk taking brought about by errors in judgment (or, perhaps more accurately in some cases, from negligence).

In a third class of models risk is misallocated, and there are two strands of risk misallocation models. In one, the mechanism that causes people to take excessive risk is knowledge that the government will step in and cover any potential catastrophic losses (risk is reallocated from the private to the public sector). This is the moral hazard problem, and the claim that government intervention led to excessive risk taking has been leveled pretty much wherever government has played a role in housing and financial markets, even when the role has not been very large.

Misallocation can come from moral hazard (government is seen to guarantee the risk), agency issues (originators are not the ultimate barers of risk) or government pressure on institutions to provide more loans to minorities.

Tyler Cowen suggests that the LTCM bail-out may have been a cause of increased moral hazard.