Merrill and the CDOs

How Merrill Lynch Traders Helped Blow Up Their Own Firm - ProPublica: "By the middle of 2006, the Merrill traders who bought mortgage securities were often clashing with the powerful division, run by Harin De Silva and Ken Margolis, which created and sold the CDOs. At least three traders began to refuse to buy CDO pieces created by De Silva and Margolis' division, according to several former Merrill employees. (De Silva and Margolis didn't respond to requests for comment.)"

John Maynard Keynes - A great investor

John Maynard Keynes - A great investor:

"John Maynard Keynes started off as a currency trader, moving to commodities a bit later on. He attempted to invest based on macroeconomic predictions—keep in mind that he was an economist—and it didn't exactly work out in the short run. I didn't quote the rest of the article but Keynes appears to have broke even later on but this was definitely a painful start."

Transaction banking

The FT looks at transaction banking:

"Few universal banks split out their transaction banking performance. But Deutsche Bank, for example, recorded transaction banking pre-tax profits of €1.1bn in 2008, up 17 per cent and equivalent to an ROE of 108 per cent. Though the number slipped back – to €776m – in 2009, that relatively stable performance contrasts with the investment banking result, which was €7.4bn in the red in 2008, thanks to the toxic asset fall-out from the financial crisis, and then €4.3bn in the black again last year."

UK Irish exposure

Ireland: a danger zone for banks:

"Settlements estimates that UK lenders account for almost 30 per cent of European banks’ total $509bn exposure to Ireland. RBS and Lloyds, both partially state-owned, have taken the most Irish pain, falling by about 8 and 9 per cent respectively over the past week before regaining some ground on Tuesday"

Negative basis in Ireland

FT Alphaville looks at the movement of Irish bonds vs CDS. In this case the bond market is leading the CDS as selling of bonds (to raise, or prevent the need to post, collateral at LCH) has been the main factor behind the move. Usually, it is the more liquid CDS that makes the move.

"Ireland joined Greece this week in the negative basis club. That is, the five-year asset swap spread for Ireland outpaced movement in equivalent credit default swaps. So (in basic terms) spreads in the CDS market were trading lower than in the cash market for Ireland."

German banks and Basel 2

FT.com "It is also a somewhat disturbing paradox that such a successful manufacturing economy remains reliant on such a fragile banking sector. Indeed, of the 44 European banks that have had recourse to state support in the latest crisis, by far the biggest number have been based in Germany, with 13 banks, followed by the UK and Belgium with five cases each"

Allocation of education

Stefan Collini discusses education reform. The bottom line, he says, is

"We can have the money for a national system of higher education distributed either in accordance with the tastes of 18-year-olds or in accordance with the tastes of a group of older people in London: there’s no other way to do it."

but does not propose an alternative. How else can education be allocated?

Private equity

Malcolm Gladwell looks at private equity and the the rescue of General Motors : The New Yorker:

"That seems about right: car companies stand or fall, ultimately, on the strength of their product, and teaching a giant company how to build a quality car again is something that can’t be done on the private-equity timetable. The problem is that no private-equity manager wants to be thought of as a mere financial engineer."

You can't buck the market

The FT Alphaville looks at the real appreciation of the Chinese currency from the increase in inflation rather than the nominal appreciation. This is a forgotten channel and one that is exacerbated by the intervention to hold the rate stable. There may be ways of sterilising in a controlled economy but it is likely that the underlying pressure will emerge in some way.

"We’ll quickly note that the Fed’s expected QE2 measures will, if successful in bringing about inflationary pressures, further add to the pressure on China to appreciate."

Alphavile argues that these inflationary pressures will increase the pressure on the Chinese authorities.

Marginal Revolution: Classical economics reading list

Marginal Revolution: Classical economics reading list:

1) Smith

2) Hume

3) Ricardo

4) Early marginalists

5) Malthus

6) Edinburgh Review

7) Mill

8) Marx

The Economist: Junk Bonds

Drexel Burnham Lambert's legacy: Stars of the junkyard | The Economist: "Junk bonds, once despised, are now mainstream. “Milken and Drexel took high-yield bonds from a cottage industry to one of the cornerstones of the financial industry,” says Howard Marks, one of Mr Milken’s early customers and now chairman of Oaktree, a Los Angeles firm that manages around $75 billion in funds, much of it in high-yield bonds and related investments."

Before the bank

Pepy's Diary 10th October 1667. Trying to find the gold that he buried at his father's house in the country.

And he being gone, and what company there was, my father and I, with a dark lantern; it being now night, into the garden with my wife, and there went about our great work to dig up my gold. But, Lord! what a tosse I was for some time in, that they could not justly tell where it was; that I begun heartily to sweat, and be angry, that they should not agree better upon the place, and at last to fear that it was gone but by and by poking with a spit, we found it, and then begun with a spudd to lift up the ground. But, good God! to see how sillily they did it, not half a foot under ground, and in the sight of the world from a hundred places, if any body by accident were near hand, and within sight of a neighbour’s window, and their hearing also, being close by: only my father says that he saw them all gone to church before he begun the work, when he laid the money, but that do not excuse it to me. But I was out of my wits almost, and the more from that, upon my lifting up the earth with the spudd, I did discern that I had scattered the pieces of gold round about the ground among the grass and loose earth; and taking up the iron head-pieces wherein they were put, I perceive the earth was got among the gold, and wet, so that the bags were all rotten, and all the notes, that I could not tell what in the world to say to it, not knowing how to judge what was wanting, or what had been lost by Gibson in his coming down: which, all put together, did make me mad; and at last was forced to take up the head-pieces, dirt and all, and as many of the scattered pieces as I could with the dirt discern by the candlelight, and carry them up into my brother’s chamber, and there locke them up till I had eat a little supper: and then, all people going to bed, W. Hewer and I did all alone, with several pails of water and basins, at last wash the dirt off of the pieces, and parted the pieces and the dirt, and then begun to tell [them]; and by a note which I had of the value of the whole in my pocket, do find that there was short above a hundred pieces, which did make me mad; and considering that the neighbour’s house was so near that we could not suppose we could speak one to another in the garden at the place where the gold lay — especially my father being deaf — but they must know what we had been doing on, I feared that they might in the night come and gather some pieces and prevent us the next morning; so W. Hewer and I out again about midnight, for it was now grown so late, and there by candlelight did make shift to gather forty-five pieces more. And so in, and to cleanse them: and by this time it was past two in the morning; and so to bed, with my mind pretty quiet to think that I have recovered so many. And then to bed, and I lay in the trundle-bed, the girl being gone to bed to my wife, and there lay in some disquiet all night, telling of the clock till it was daylight.

Internalising

FT Alphaville discusses the internalising of equity market in large investment banks. This means that the bank nets the buy and sell orders and sends the balance to the exchange.

"As for the proportion of trading conducted this way? According to the last stats seen by FT Alphaville, something like 31 per cent of all US equity orders were being internalised as of January, 2010."

Networks and liquidity

David Warsh points us to Paul David and an essay on the "flash crash". The end to open outcry may have some effects that allow the transmission of shock or 'catastrophe beyond what would previously have been the case. It is a story of fragmented liquidity and an end to face-to-face dealing.

Still, if it’s the crash itself that is of interest, you’ll do better reading the SEC report. It is the larger dimension of the signal that interests David. He invokes the work of French mathematician René Thom, inventor in the 1970s of a formal mathematics of sudden shifts, of qualitative breaks or discontinuities, that he called catastrophes. “To appreciate that quality it is helpful to start from the mathematical rather than the ordinary language meanings conveyed the term,” David writes.

A commonplace physical illustration of a “catastrophic event” – in this formal sense of the term — may be experienced by letting your finger trace the surface of a draped fabric until it reaches a point where the surface (the “manifold” as mathematicians would speak of the shawl or cloak’s three-dimensional surface) has folded under itself; there gravity will cause your finger’s point of contact to drop precipitously from the surface along which it was traveling smoothly – to land upon the lower level of the drapery beyond the fold. That little passage is the “catastrophe.” In the present context, what is especially relevant about this conceptualization of the “event” experienced by your finger is its generic nature: catastrophes thus conceived are not phenomena belonging to a category delimited by some size dimension of the system in which they occur, or according to the severity of their sequelae; nor are they to be uniquely associated with processes that that operate only in one or another range of temporal velocities (whether slow, or fast). Instead, the catastrophes to which this essay’s title refers are fractal, possessing the property of self-similarity.

Similar to what? He compares the conditions that led to the May 6 price break to the phenomenon known as “flaming.” One party breaks off a previously civil exchange with hostile abusive comment. Instead of turning it aside, others sometimes reciprocate. Anonymity is the key part of the process; isolation seems to remove inhibitions that would brake the process if the exchanges took place face to face. Silence ensues, or, worse yet, digital versions of what long ago were called “slam books” – compendia of the faults of others, sufficient to fragment the conversation once and for all. (This is the problem with Glen Beck and much of the rest of Fox News.)

Humans evolved to recognize from infancy the effect of their actions on others – facial expressions, body language, tone of voice, he notes. On the Internet, however, no one knows when they may come across as a flame-throwing tank. It is why humor is so risky on the Web.

Exchange traded fx products

FT.com discusses the lack of growth in ETP in the FX space. However, there is an interesting product from Deutsche Bank that tries to combine three basic strategies. One case study could try to set the rules for such a product.

"For investors who do not want to take simple long/short positions, an alternative tactical approach to foreign exchange markets is offered by Deutsche Bank and its db x-trackers currency returns ETF. This combines three strategies widely used by traders in currency markets: carry, momentum and valuation. Like a quantitative hedge fund, it uses a rules-based process to take long and short positions in G10 currencies with regular rebalancing of the components."

Market or command

A comparison of social network and command as a means of organisation.

In a new book called “The Dragonfly Effect: Quick, Effective, and Powerful Ways to Use Social Media to Drive Social Change,” the business consultant Andy Smith and the Stanford Business School professor Jennifer Aaker tell the story of Sameer Bhatia, a young Silicon Valley entrepreneur who came down with acute myelogenous leukemia. It’s a perfect illustration of social media’s strengths. Bhatia needed a bone-marrow transplant, but he could not find a match among his relatives and friends. The odds were best with a donor of his ethnicity, and there were few South Asians in the national bone-marrow database. So Bhatia’s business partner sent out an e-mail explaining Bhatia’s plight to more than four hundred of their acquaintances, who forwarded the e-mail to their personal contacts; Facebook pages and YouTube videos were devoted to the Help Sameer campaign. Eventually, nearly twenty-five thousand new people were registered in the bone-marrow database, and Bhatia found a match.

The broad theme is that command is necessary for real, serious, important and difficult tasks; social networks are broader, more creative and more trivial.

Commodity fund

All About Alpha investigates commodity funds.

Because of the capital costs of holding commodities directly, investing is almost exclusively done using futures (exceptions include commodity producers, consumers, etc.) Commodity indices, ETFs, ETNs and mutual funds manage their portfolios very similarly when using futures contracts. For the most part, they construct the portfolio by purchasing near-dated futures contracts. As the contracts near maturity, they sell the contract at or near the spot price of the commodity and purchase new near-dated contracts and the process repeats itself. The frequency and magnitude of this roll leads to the importance of the yield it generates.

Unfortunately, investing in commodity futures contracts can be complicated since total returns are comprised of three return components:

• Collateral Yield: Futures contracts require very little collateralization (~10%). The remainder is frequently invested in high-quality, short-term instruments such as a 90-Day T-Bill. The yield from these investments is often very small relative to the total return and is known as the collateral yield.

• Spot Price Change/Yield: This represents the price change in the underlying commodity contract and is often quoted during a discussion of a commodity’s return. Investors are usually seeking exposure to these returns when choosing to invest in commodities.

• Roll Yield: This component of return is the focal point of the recent articles and is a little more complicated. Commodity investors (e.g. indices, funds, etc.) tend to buy near-dated contracts (e.g. 1-month from expiration) and sell them just prior to settlement. The revenue generated is immediately used to purchase another near-dated contract to maintain exposure to the commodity. This process continues indefinitely and represents the roll yield (sale price less purchase price). If the subsequent purchase cost is less than the revenue gained from the sale, then the roll yield is positive; if the sale prices is less than the purchase price the roll yield is negative. A positive roll yield is referred to as backwardation while a negative yield is called contango.

Information

Ben Bernanke looks at what the financial crisis means for economics. In the middle of this there is an overview of information and expectations under uncertainty.

Most fundamentally, and perhaps most challenging for researchers, the crisis should motivate economists to think further about their modeling of human behavior. Most economic researchers continue to work within the classical paradigm that assumes rational, self-interested behavior and the maximization of "expected utility"--a framework based on a formal description of risky situations and a theory of individual choice that has been very useful through its integration of economics, statistics, and decision theory.⁹ An important assumption of that framework is that, in making decisions under uncertainty, economic agents can assign meaningful probabilities to alternative outcomes. However, during the worst phase of the financial crisis, many economic actors--including investors, employers, and consumers--metaphorically threw up their hands and admitted that, given the extreme and, in some ways, unprecedented nature of the crisis, they did not know what they did not know. Or, as Donald Rumsfeld might have put it, there were too many "unknown unknowns." The profound uncertainty associated with the "unknown unknowns" during the crisis resulted in panicky selling by investors, sharp cuts in payrolls by employers, and significant increases in households' precautionary saving.

The idea that, at certain times, decisionmakers simply cannot assign meaningful probabilities to alternative outcomes--indeed, cannot even think of all the possible outcomes--is known as Knightian uncertainty, after the economist Frank Knight who discussed the idea in the 1920s. Although economists and psychologists have long recognized the challenges such ambiguity presents and have analyzed the distinction between risk aversion and ambiguity aversion, much of this work has been abstract and relatively little progress has been made in describing and predicting the behavior of human beings under circumstances in which their knowledge and experience provide little useful information.¹⁰ Research in this area could aid our understanding of crises and other extreme situations. I suspect that progress will require careful empirical research with attention to psychological as well as economic factors.

This can be tied to the modelling of expectations in the UIP model. There may be a non-linear model that is distributed with a negative skew and kurtosis in regular times and collapses into something binary in a crisis.

Not poisoned but starved

Gary Wenk speaks about "brain food" and the way that the shared ancestory of ourselves and plants makes components of our food most effective in affecting our bodies and minds. Amidst this:

No, he does not die, because his species and that of the creature on this foreign planet do not share an evolutionary past or a common ancestor. Although they may both be made of proteins formed from amino acids, their independent evolutionary paths should made it highly improbable that they use similar neurotransmitter molecules within their respective brains and bodies. Every spaceman from Flash Gordon to Captain Kirk to Luke Skywalker should feel safe walking around any planet (except their own) with impunity from animal and plant toxins. For this same reason, the intoxicating drinks and powerful medicines that always seem to be popular in these foreign worlds in science fiction movies would also have totally different effects, if any effects at all, on the brains of our plucky spaceman. Eating otherworldly foods might be the most disappointing and distressing experience of all: Even if they were filling and somehow tasted delicious, as products of utterly alien biochemistries they would probably prove devoid of nourishment for our Earthly bodies. Thus, starvation might be the greatest threat to any future explorers of alien biospheres. Unless, perhaps, they’d brought along a large supply of chocolate.

Risk

Another look at the nature of risk in the coverage of EMH in the FT.

Second is the pro-cyclical nature of value-at-risk, a measure of the risk of loss. Recent high market volatility is sharpening attention towards risk and the need to measure and manage it. At the same time, rapid financial innovation has increased the ability to monitor and control risks, allowing measures like Var to gain further ground. This would all be good news, if the markets were using the right type of Var for establishing the risk limits.

Generally, when prices move down, Var goes up, eventually triggering the risk limits and thus enlarging the troops of sellers. Symmetrically, the reduction of Var in good times encourages traders and fund managers to pile on risk, increasing their risk exposures when prices are already high and while demand is thriving. This can compound the positive feedback mentioned earlier.

The interesting thing here is the way that a period of low volatility will provide a sample of low volatility and increased risk taking. Increased volatility leads to less risk taking. Can we model this?

Mobile phone and microfinance

Amidst a discussion of mobile phones in Kenya in the Guardian, the possibility that microfinance improvements may also be seen.

Besides enabling millions of people to easily communicate over distance for the first time, the mobile phone has spurred a host of other life-improving innovations, including a money transfer service that allows people to send cash instantly across the country via text message.

Washington Consensus

Interesting! I had never seen this before.

From Ronald McKinnon.

John Williamson (1990) did all a great favor by writing down the rules for what he called “The Washington Consensus” for developing countries to follow to absorb aid efficiently:

1. Fiscal policy discipline.
2. Redirection of public spending from subsidies (“especially in discriminate subsidies” toward broad-based provision of key pro-growth, pro-poor services like primary education, primary health care, and infrastructure;
3. Tax Reform—broadening the tax base and adopting moderate marginal tax rates:
4. Interest rates that are market determined and positive (but moderate) in real terms;
5. Competitive exchange rates;
6. Trade liberalization—with particular emphasis on the elimination of quantitative restrictions; any trade protection to be provided by low and relatively uniform tariffs;
7. Liberalization of inward foreign direct investment;
8. Privatization of state enterprises;
9. Deregulation—abolish regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions.
10. Legal security for property rights.

To provide perspective on these ten rules, the year 1990, when Williamson wrote, is important. It was just after the fall of the Berlin Wall and the complete collapse of confidence in Soviet-style socialism. The rules reflect the hegemonic confidence that most people then had in liberal market-oriented capitalism—think Ronald Reagan and Margaret Thatcher. But, 20 years later, should the meteoric rise of socialist China—both in its own remarkable growth in living standards, and in the effectiveness of its foreign “aid” to developing countries, undermine our confidence in Williamson’s Washington Consensus?

Copyright and competition

De Spiegel discusses work by Wolfgang Menzel that suggests that an absence of copy right in Germany was responsible for a flourishing of ideas. In contrast to England, where copyright laws kept monopoly power over ideas and prevented competition, in Germany there was an outpouring of non-fiction publishing. German publishers reacted to their inability to enforce their rights by using price discrimination to cover the market.

In Germany during the same period, publishers had plagiarizers -- who could reprint each new publication and sell it cheaply without fear of punishment -- breathing down their necks. Successful publishers were the ones who took a sophisticated approach in reaction to these copycats and devised a form of publication still common today, issuing fancy editions for their wealthy customers and low-priced paperbacks for the masses.

European money markets

Some interesting comments on the state of the money market in Europe. It appears that things remain very tight and that collateral is increasingly demanded.

What Comotto emphasises, however, is that while that trend may have begun as far back as the 1990s, the recent European crisis has now nearly completely vaporised what little unsecured interbank lending was left in the market. What’s more, the demand for tri-party transactions — where collateral is managed by a custodian rather than bilaterally — has almost doubled from less than 25 per cent before the Lehman crisis to almost 50 per cent since.

This is from Richard Comotto of the European repo market, quoted in the FT's Alphaville. There is a lot more interesting information on the repo and money markets. //

Power law and SMEs

More evidence of a power law.

The National Endowment for Science, Technology and the Arts, an independent trade body, calculates that just 6 per cent of the highest growth businesses generated 54 per cent of new jobs over the last decade.

This is important because it means that it is a few high quality SME creations that generate all the social benefit as well as the profit. More from the Financial Times Lex column,

Changes in microsctures

Raijiv Sethi raises the idea that increased focus on algorithmic trading is removing the support for smaller size capitalisation and reducing the number of public limited companies.

In addition, stock market structure today is geared for large‐capitalization stocks with typically symmetrical order books but disastrous for the vast majority of small‐capitalization stocks with asymmetrical order books (where there is not naturally an offsetting buy order to match against a sell order and vice versa)... The “Flash Crash” was an example of where even normally liquid securities went to a state of “asymmetry” and price discovery broke down...

[Until] all trades, quotes and other messages in all interrelated markets are tagged and traceable to the trading venue, broker and ultimate investor, and disclosed to the market, markets will not be perceived as fair... With full tagging, tracking and reporting and the application of posttrade analysis and test bed techniques such as Agent‐Based Models, regulators and market participants will... once and for all be in a position to judge the impact of other participants and to regulate and plan accordingly...

Liquidity Preference

Keynes:

Because... our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.... The significance of this characteristic of money has usually been overlooked; and in so far as it has been noticed, the essential nature of the phenomenon has been misdescribed. For what has attracted attention has been the quantity of money which has been hoarded... supposed to have a direct proportionate effect on the price level through affecting the velocity of circulation. But the quantity of hoards can only be altered either if the total quantity of money is changed or if the quantity of current money income (I speak broadly) is changed; whereas fluctuations in the degree of confidence are capable of... modifying... the premium which has to be offered to induce people not to hoard. And changes in... liquidity preference... affect, not [consumer] prices, but the rate of interest.

Keynes and uncertainty

Keynes in the 1937 Journal of Economics take another look at uncertainty.

By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain.... The sense in which I am using the term is that in which the prospect of an European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters their is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation.... How do we manage?... (1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it.... (2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects.... (3) Knowing that our individual judgment is worthless, we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed....

The key here seems to be a vague and embryonic outline of some of the ideas of behavioural finance. How do we deal with uncertainty when there is no basis to make an estimate of probabilities? What short-cuts can the mind use to deal with these issues? One of the things that Keynes suggests here and the The General Theory is the idea that we assume that things will be rather similar to how they have been in the past. This is probably a reasonable starting point. It is conservatism. Another thing that Keynes suggests is that we look to the opinion of others. Here we get the basis for a social construction of belief.

Market making or trading

There is a lot post on the FT's Alphaville looking at the position of Jerome Kerviel. There is a blurring of the distinction between market-maker and proprietary trader. The fact that cash positions were carried over from one day to the next is taken as a sign that there was more than just market-making going on.

Run on the bank

Pepy's diary 13th June 1667, in the wake of the Dutch attack on Chatam:

I presently resolved of my father’s and wife’s going into the country; and, at two hours’ warning, they did go by the coach this day, with about 1300l.in gold in their night-bag. Pray God give them good passage, and good care to hide it when they come home! but my heart is full of fear: They gone, I continued in fright and fear what to do with the rest. W. Hewer hath been at the banker’s, and hath got 500l. out of Backewell’s hands of his own money; but they are so called upon that they will be all broke, hundreds coming to them for money: and their answer is, “It is payable at twenty days — when the days are out, we will pay you;” and those that are not so, they make tell over their money, and make their bags false, on purpose to give cause to retell it, and so spend time. I cannot have my 200 pieces of gold again for silver, all being bought up last night that were to be had, and sold for 24 and 25s. a-piece.

Power law

O2 indicate that the use of bandwidth is partly determined by a power law.

More here from the Guardian.

Instead, it said that a tiny number – just 1% 0.1% (corrected: incorrect figure given by O2 initially) of smartphone users – are using 36% of its total mobile data traffic, and that they needed to be encouraged to change their behaviour.

Identity economics

George Akerlof and Rachel Kranton's identity economics is reviewed by Whimsley.

Greed is good

What determines utility? Eric Falkenstein argues that envy is more important that greed. This is consistent with some of the findings of behavioural experiments. This can provide a better understanding of bubbles as it would indicate that keeping up with other bubble followers is one reason that many people are sucked in. It also suggests that the best investment strategy is one that is individualistic and greedy. An example would be Warren Buffett and the technology boom. It also suggests that hedge funds that follow an independent strategy and do not worry about relative performance will be better in the long run.

Subordinated debt

Amidst a discussion of the difficulties facing Greek restructuring of its debt, John Dizard gives a good overview of subordinated debt.

As I have written, Greece is in a better legal position to reschedule its sovereign debt on favourable terms than, say, Argentina back at the end of 2001. About 90 per cent of Greek sovereign debt is in the form of bonds governed by Greek law.

That means if Greece wants to reschedule the interest rate and maturity of its debt, its national parliament can just pass a law decreeing the new terms. Investors would have no legal recourse.

The practical problem with doing that unilaterally is that Greece is still running large fiscal and trade deficits, so it cannot yet run its economy on a cash basis, as Argentina and others did after their defaults. That is why the European Union-International Monetary Fund stabilisation package is needed to cover maturing debt issues and also the continuing twin deficits, at least for the three years the facilities are supposed to be in place.

From the Greek point of view, though, it doesn't make sense for the three-year plan to run its course, even if the country meets its financial targets. Assuming it all works, Greece would have a substantially higher debt that would not be in the form of loosely covenanted Greek-law bonds, but virtually un-defaultable obligations to European governments, the EU and the IMF. The notion that banks or bond investors would be willing, at that point, to offer deeply subordinated credit to Greece is mere fantasy.

Profits from prop trading

In the continued search for profits generated by prop trading, this from the FT story on the likely effect of bank regulation on revenues

The so-called Volcker rule would be slightly less feared. Prop trading is not as profitable over the long run as many realise, but if banks are also forced to stop investing in hedge funds and private equity, normalised earnings could fall by about 2 per cent, according to Goldman Sachs.

There is also this from Tyler Durden

So with a delay of about six months since Zero Hedge started pounding on the topic of prop trading as the last bastion of perfectly legal front-running, which co-opts clients into "efficient" flow execution with the few remaining monopolist entities left on Wall Street in exchange for assorted prop trading desks taking advantage of complete flow visibility (i.e., the hedge fund nature of all modern Wall Street bail out recipients) which is simply a way to run alongside (or in front of) whale orders, thus providing guaranteed and risk free returns, the administration has finally realized what we have claimed for many months: that prop trading is nothing but a quasi-illegal operation, which was made explicitly and perfectly permissible with the adoption of the disastrous Gramm-Leach-Bliley act. As long as prop trading exists, Goldman (which is reporting earnings tomorrow, and we expect will announce another quarter of 90%+ profitable trading days only thanks to it taking full advantage of a thorough visibility of the FICC and equity flow market and a commingled prop and flow order book) will have record earnings, until such time as the Minsky Moment in Goldman's balance sheet arises again and blows up the financial system one more time.

Measuring inflation

The Cleveland Fed reports some new research by Bryan and Meyer that tries to break price changes down into those that are frequent and those that happen only occasionally. The occasional changes are seen as being affected by the outlook for future inflation and therefore provide a signal about inflation expectations. They produce a flexible price index and a sticky price index. The sticky price index seems to contain some valuable information that improves the forecast of future inflation.

No need for bank diversification?

The FT's Lex asks why BoA is divesting assets in strongly growing Brazil and concludes that increased capital requirements and reduced leverage reduces the need for diversification to stabilise earnings.

A potential answer is that global banking models are being subtly revised in response to increased regulation. One of the little understood mysteries of the boom years is why banks expanded internationally when there were no synergy benefits and shareholders could themselves diversify more efficiently. The reason was leverage: if you are 30 times geared, it is crucial to have a stable earnings base. Geographic diversification was one way to get it, even if returns in individual countries were low.

Exchanges, liquidity and stock gyrations

The wild swings in US equity markets that were seen last Thursday have generated a lot of talk about the current structure of equity markets and the increased role of automated trading.

It appears that, with multiple exchanges, the closure of some markets may just increase the reliance on more peripheral, less liquid alternatives. The traditional specialist on the floor of the NYSE is no longer a backstop to prevent a collapse in price.

James Hamilton

Another notion that's popular with many financial gurus these days is the claim that you can eliminate certain risks to your portfolio with the right strategy of automatic trading and stop-loss sell orders. Again that claim invites an economic question-- if you are getting an insurance policy, who is selling it to you? I believe the implicit answer is, you are counting on the market-maker to insure you by taking the other side of your escape transactions. But the curious thing about such an insurance policy is that the market-maker gets to decide what premium to charge you after you ask to collect on the policy. You just might find that the state of the world when you and your buddies all most desperately want to cash in on your insurance is exactly the time when the premium proves to be ruinously expensive.

Paul Kedrosky

But all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim. As a result, in market crises, when liquidity was always hardest to find, it now doesn't just become hard to find, it disappears altogether, like water rushing out sight via a trapdoor to hell. Old-style market-makers are standing aside as panicky orders pour in, and they look straight at shadow liquidity providers and say, "No thanks. You battle bots take it". And, they don't

The FT on algorithmic trading.

The FT looks at the regulatory impact.

Larry Tabb, chief executive of consultancy The Tabb Group, says: “We really need to step back and think about centralisation versus fragmentation and who is providing liquidity. It opens the up market to a whole series of questions about how we want our markets to function.”

Trading Places

Increased risk

European banks are suffering increased funding costs as a result of fears over Greek contagion. From the FT.

A key measure of bank risk, the overnight index swap spread on futures contracts in the eurozone, rose to a record high this week. This measures the premium over “risk-free” overnight rates of three-month rates, which carry greater credit risk.

Another warning sign is a significant shift to overnight lending by banks, particularly within troubled areas of the eurozone. Of the €450bn ($589bn) in daily turnover in the European money markets, 90 per cent is now in overnight lending, according to interdealer broker

Article 125 of the Lisbon Treaty

1. The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

2. The Council, on a proposal from the Commission and after consulting the European Parliament, may, as required, specify definitions for the application of the prohibitions referred to in Articles 123 and 124 and in this Article.

Deep knowledge

The FT covers the case against the rating agencies and highlights the fact that there was knowledge within the institution about the reputational risk being taken. The FT suggests that this was profit-motivated, which is certainly part of the story. However, it may also be the case that these dispirit, lower-level voices could not be hear above the jingling of the tills ringing in new business. The challenge of governance is to give more weight to these voices.

he e-mails show signs of the agencies’ knowledge of the impending financial collapse. But in the interests of maintaining market share both S&P and Moody’s felt the need to continue their practices – even though many employees had misgivings.

“Screwing with (the model’s) criteria to ‘get the deal’ is putting the entire S&P franchise at risk – it’s a bad idea,” said one S&P employee. Another S&P employee described the drive for revenue and its effect on the relationship between banks and rating agencies as “a kind of Stockholm syndrome”.

Yet another captures that alleged conflict of interest almost perfectly: “Rating agencies continue to create an even bigger monster – the CDO market,” wrote an S&P staffer. “Let’s hope we are all retired by the time this house of cards falters.”

The agencies also failed to incorporate their growing awareness of fraud in the lending industry into their rating practices, as it was seen as a potential block to revenue.

In January 2007, an S&P analyst rating a Goldman Sachs CDO with subprime loans issued by Fremont Investment and Loan, which had just stopped using 8,000 of its brokers because they were agreeing loans with some of the highest delinquency rates in the country, asked superiors whether to take Fremont’s reputation into account.

Speculation

Pepy's diary 15th March 1666

So I to the office all the morning, and at noon to the ‘Change, where I do hear that letters this day come to Court do tell us that we are likely not to agree, the Dutch demanding high terms, and the King of France the like, in a most braving manner. The merchants do give themselves over for lost, no man knowing what to do, whether to sell or buy, not knowing whether peace or war to expect, and I am told that could that be now known a man might get 20,000l. in a week’s time by buying up of goods in case there should be war.

CDS

John Kay

But it strains language to breaking point to describe CDS transactions as anything but gambling. The traders in AIG’s financial products division were inheritors of the amusements of Edward Lloyd’s coffee shop rather than the values of Swiss farmers.

I am not sure that this is an accurate description. It seems to me that AIG was taking the risk from the Swiss farmers and receiving the income for total collapse that they did not believe could happen. However, when all the crops failed, AIG could not compensate the farmers and had to be bailed out by the government. There is speculative trading there, but it is not being done by AIG.

Theomdynamics

The first and second laws of thermodynamics: work uses energy and systems are inefficient. A good example with Google search in New Scientist. However, as if often the case when talking about thermodynamics and economics, there is no accounting for the fact that society, unlike the real world, can create something out of nothing.

Things like economies of scale and network effects have confounded people from Smith to Malthus to Marx. In this case, there is a need to compare the cost (lightbulb for one hour) against any possible benefit.

Currency swap

The FT reports that Greece may try to tap US investors with a US dollar-denominated bond, giving some evidence of institutional features that may justify currency swaps.

Greece’s most recent sales of euro-denominated bonds have attracted lower levels of interest and the government is now aiming to issue in dollars, targeting emerging market investors who are attracted by higher yields.

Bond model

Here are some links to research on the yield curve.

http://www.econbrowser.com/archives/2006/07/reading_the_yie.html

http://www.econbrowser.com/archives/2006/11/the_yield_curve_2.html

http://economistsview.typepad.com/economistsview/2006/09/globalization_a.html

http://www.econbrowser.com/archives/2009/04/the_yield_curve_6.html

http://www.econbrowser.com/archives/2006/04/the_yield_curve.html

http://economistsview.typepad.com/economistsview/2008/02/accounting-for.html

http://economistsview.typepad.com/economistsview/2005/06/speculation_on_.html

http://economistsview.typepad.com/economistsview/2006/01/why_is_the_yiel.html

Though funding costs are high, there is ample demand at the long end of the market. The FT reports.

Indeed, the first plea of Joanne Segars, the NAPF chief executive in its pre-Budget submission was to ask that borrowing be tilted to the long end of the market where it can do the most to alleviate funding woes for pensions. Already, government issuance of 20-, 30- and 50-year debt has risen sharply. In the fiscal year ending April 2010, issuance of conventional long-dated gilts soared to £33.9bn from £23.4bn just two years earlier. Thirty-year yields have risen, too, from 4.09 per cent at September 30 2009 to 4.52 per cent as at March 31 2010

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Crisis, margin and profits

The FT reports the fall back in margins towards pre-crisis levels.

The trouble is, with margins near pre-crisis levels again for products like rates and forex, the free lunch enjoyed by the smaller boys is being taken away. Scale once more is king. Banks down the order in certain flow products should be asking themselves serious questions. Even including the crisis, the top five banks in equities, for example, have increased their market share by 10 per cent since 2006. As the level of concentration increases again, expect more money – not to mention heat – to be generated in the biggest dealing rooms.

Swaps and noise

Here is an example from the FT about how arbitrage opportunity may be squeezed by noise.

In the wake of the financial crisis, the use of collateral backing derivative trades in order to appease counterparty credit concerns has continued to expand.

This means that once a swap trade is executed, more margin is required if the trade starts losing money.

This daily management of margin also makes it harder to maintain an arbitrage over time as the value of any trade between swaps and Treasuries changes constantly.

Analysts at Credit Suisse say: “This makes it increasingly harder to hold arbitrage strategies to termination as arbitrageurs are forced to realise not just gains but also losses through margin calls resulting in frequent stop outs [forced exits from the trade].

The risk that the trade will move further in the wrong direction before convergence is achieved will limit those willing to take the risk and create some sort of threshold on arbitrage. This may be like a threshold error correction model similar to that seen in PPP.

Growth and bubbles

Here is a section on bubbles and the growth rate by Nick Row.

Shorting bonds

A small FT item on shorting the bond market. There are a number of different ways to do this: futures, repos or CDS.

Shorting bonds can be done using futures or repos [repurchase agreements], or credit default swaps. The last method is not ideal, warned Mr Inker. “There is the risk of governments declaring your contract invalid.” A number of politicians have called for restrictions on CDS trading.

This is a strategy designed to enhance yield in a low interest rate world. Risk-reward is in favour of high yields.

Informal contracts

John Kay summarises the difference between informal and explicit contacts echoing ideas about the need for flexibility in relationships that cover the question of where the firm should end and the nature of the legal background to firm formation: Coase and Williamson highlight some of these issues as informal and adaptive relationships may be more easily managed within the firm.

Lawyers for American companies spent hundreds of billable hours drawing up contracts to which no one ever referred. Their Japanese counterparts engaged in complex business relationships with no formal agreements at all, or ones that covered a single sheet of paper. But the commercial relationships that emerged in Japan’s car industry were more successful in securing component reliability and managing just-in-time inventory than those hammered out by the hard-nosed negotiators of Detroit.

La Porta, DeSilanes, Shliefer and Vishney "Legal Determinants of External Finance" seem to suggest that a more flexible legal system can also better deal with the heterogeneity of conflicts.

Banking, risk and regulation

Excellent article on risk and regulation that looks at the key issues of failure in safe securities and repo markets.

The financial crisis of 2007-09 featured large-scale losses to financial institutions from assets such as AAA rated tranches of mortgage-backed securities. Simultaneously, markets for collateralised borrowing (“repos” or repurchase agreements) froze or experienced severe stress. Investors lending in repo transactions started charging large “haircuts”. In other words, repos could be rolled over only with successively high levels of over-collateralisation, which disrupted the financing model of broker-dealers and in fact caused Bear Stearns to fail in March 2008.

The moral of the story is that regulators need to impose tighter constraints, such as higher capital requirements, on activities such as holdings of AAA rated tranches and repo financing of risky assets where there is a conflict of interest between the privately optimal and socially optimal choices. Bankers will fight such a proposal. But it should be well understood that they have all incentives to ignore the attendant systemic risk

Minsky and risk

Rajiv Sethi: An Ecological Perspective on Financial Market Reform speaks about Minsky and the way that risk was built at financial institutions.

Swap rates

The FT on the relationship between government issuance and swap rates.

In normal market conditions, yields on government bonds, such as US Treasuries, UK gilts and German Bunds, trade at a discount to swap rates. This is because swap rates are based on a funding rate that is linked to the interbank lending market. This rate is higher than the repo rate used for financing government bonds. Swaps are money market instruments whereas Treasuries reflect triple A sovereign risk.

Toxic asset

Track a toxic asset with NPR.

Remember those complicated bonds full of home mortgages? The ones that almost brought down the economy? A team of reporters with NPR's Planet Money used $1,000 of their own cash to buy a tiny piece of one — and plan to track it until it dies

Extreme value

Arthur Charpentier shows very clearly the way that mean square error and average absolute error can diverge as outliers appear.

(I allowed negative income for simple calculations and have a nice design). We concluded that gap significantly different between the standard deviation (L2) and the absolute difference (L1) simply means that there are probably outliers in the database (outliers defined "significantly different" means " outliers ").

Lehman

The FT looks at the Lehman repo transactions but what stands out is the huge increase in risk-taking.

Lehman’s rapid growth saw net assets increase by 48 per cent, or almost $128bn, from the fourth quarter of 2006 through the first quarter of 2008. But the bulk of the assets, according to the report by court-appointed examiner Anton Valukasreleased on Thursday, were in illiquid assets that could not easily be sold. Such assets nearly doubled to $175bn in that same time frame

The repo issue is that this was used to disguise the extent of the leverage and the precarious financial position that the investment bank had engineered. If they were conducting this financial engineering, they were aware of the increase in risk that was being taken.

Sussex history

Sussex history and Charles 2.

Moral Hazard and selection

Mark Thoma puts together an excellent item on moral hazard and natural selection. The banks do not even have to believe that what they are doing is risky. So long as the most successful continue to rise and the relative failures throw in the towel, risk will increase. There is also a good point about the nature of beliefs and the way that they are only over-turned after sufficient weight of contrary evidence.

Robin Hood Tax

A nice example from Tim Harford of the risk that Tobin tax increases volatility.

The tax would certainly be attractive if, like a tax on carbon dioxide or congestion, it reduced destructive activities. But would it? James Tobin and John Maynard Keynes both proposed taxes on financial transactions and each believed that the tax would reduce financial volatility. This is possible but far from obvious, when you realise that the tax might encourage bigger, more irregular financial transactions. An analogy: if I have to pay a charge whenever I use a cash machine, I make fewer, larger withdrawals and the amount of money in my wallet fluctuates more widely. Bear in mind, too, that the most bubble-prone asset market is for housing, which is bought in very lumpy, long-term chunks

Governance

John Lewis vs EasyJet. Below the political rhetoric is an interesting argument over the nature of governance. Labour plans to concentrate on mutualism with people paid to participate; the Conservatives aim for pick-and-mix services.

From the Guardian.

Labour is planning to rebrand one of its local authorities as Britain's first "John Lewis council", offering council tax rebates to residents in exchange for helping to run services, in a direct challenge to the Conservatives' pioneering "easyCouncil".

Paul Samuelson

In the New Yorker being interviewed by John Cassidy.

Rights issue

This is a very good overview of rights issue regulations around the world from the FT.

Chinese revaluation

Calculated Risk links to a number of sites talking about Chinese revaluation.

Interest rates and financial growth

Looking at the relationship between the level of interest rates and the size of the financial sector suggests that relatively high interest rates encourage the growth of the financial sector. The high interest rates allow an inflow of funds which have to be managed.

This can take a panel analysis.

1990 or first available year 2007 or latest available year average interest rate

India 11.9 14.2
Russian Federation 0.8 14.7 8.86
Slovak Republic 14.8 16.9 4.93
Czech Republic 16.9 17.3 3.24
Norway 17.4 17.9 4.59
Poland 10 18.4 8.42
Greece 16.7 19.4
Turkey 11 20.2 17.5
Mexico 20.7 20.3 9.31
Finland 16.2 21.2 3.18
Korea 14.9 21.6 4.67
Spain 17.2 22.1 3.18
South Africa 16.1 22.1 9.12
Portugal 20.2 22.4 3.18
Hungary 14.6 22.6 4.9
Switzerland 16.2 23.6 1.58
Austria 17.7 24.2 3.18
Denmark 21.5 24.7 3.38
Sweden 20.3 24.8 2.91
Brazil 25.4
Canada 22.7 25.6 3.32
Iceland 16.7 26.2 10.63
Japan 20.7 26.7 0.36
Italy 20.1 27.6 3.18
Ireland 16.4 28.1 3.18
Netherlands 20.7 28.3 3.18
New Zealand 25.4 28.3 6.35
OECD total 24.3 28.4
Belgium 22.6 29 3.18
Germany 23 29.2 3.18
Australia 25.2 29.8 5.72
United Kingdom 21.6 31.9 4.54
United States 24.8 33.1 3.2
France 27.1 33.3 3.18
Luxembourg 28.5 47.3 3.18

(file is OECD rates and size of the financial sector)
There is probably a need for some dummy variables to account for the US reserve currency status, UK history and the developments in Ireland and Luxembourg. What other explanatory variables?

The carry trade

The FT explains the carry trade.

Contagion

The Epicurean Dealmaker highlight a way that contagion can spread from one market to another.

Well, consider this. A fund with a highly levered balance sheet, and its investment fingers in many pies, is hit with losses in one of its sub-portfolios. Due to the nasty two-edged bite of leverage, its equity drops significantly, and the only way it can restore its risk profile is to raise more equity or liquidate some of its investments. Given the poor market conditions in the affected sub-portfolio, it is often more prudent to liquidate securities in other sub-portfolios. But this, as you can imagine, puts downward price pressure on securities in those previously unrelated markets. Presto, contagion. This is the "common holder" problem which some believe is the primary culprit.

US bond auctions

A very interesting item on US bond auctions and the way that indirect bidding has become more apparent.

For the past year, as the size and number of US Treasury debt sales each month has surged in order to fund the gaping US budget deficit, there has been increasing evidence of “direct” buying activity. But last week the trend became particularly apparent when big chunks of the three and 10-year note auctions were bought by domestic investors such as large money managers, hedge funds and smaller US financial institutions.

Monetary policy

John Plender makes that point that monetary policy was asymmetric.

The academics who dominate modern central banking were ideologically committed to the notion of efficient markets and to exclusive reliance on inflation targetting regardless of imbalances arising from easy credit and soaring asset prices – a spectacular case of one-club golfing. This mindset led to the silly belief that bubbles could not be identified at the time and that it was better to clean up after the bust than to lean pre-emptively against the wind in the boom. Monetary policy was thus asymmetric. Interest rates were reduced when asset prices fell, but were not raised in response to wildly overheating markets.

Risk aversion

Here is an excellent overview of risk aversion.

Geometric Mean
Another alternative to mean-variance is to select the portfolio that has the highest expected geometric mean return. This, in effect, maximizes the expected value of terminal wealth.

The geometric mean is defined as:



where Rij is the ith possible return on the jth portfolio and each outcome is equally likely.

If the likelihood of each outcome is different and Pij is the probability of the ith outcome for the jth portfolio, then



and can be written as,


The resulting portfolio is usually very well diversified and extreme values have a tendency to be eliminated. If a strategy has a probability of bankruptcy then the whole product will become zero.

The geometric mean is a measure of central tendency, just like a median. It is different from the traditional mean (which we sometimes call the arithmetic mean) because it uses multiplication rather than addition to summarize data values. Geometric means are often useful summaries for highly skewed data.

The geometric mean for any time period is less than or equal to the arithmetic mean. The two means are equal only for a return series that is constant (i.e., the same return in every period). For a non-constant series, the difference between the two is positively related to the variability or standard deviation of the returns.

The main problem with this method is that it does not differentiate between investors and thereby does not explicitly refer to risk. If our expected return forecasts were the same, then every investor, irrespective of their circumstances, would hold the same portfolio.

Arguably, this method could be used by a mutual fund that has a broadly diversified group of investors. It is very quick and easy to use.

Maximizing the geometric mean is equivalent to maximizing the expected value of a log utility

Chinese development

Daniel Gross in Slate on China.

Second, much of China's extraordinary development has been based on moving peasants into manufacturing. The key to future job growth, says Stephen Green, chief economist at Standard Chartered Bank in Shanghai, will lie in the services sector. And the largest components of the services sector—financial services, entertainment, media—remain firmly in the grip of the state. Going forward, it will become more difficult for a services-based economy to prosper with restraints on communication and expression. China faces a fundamental paradox, says Damien Ma, an analyst at the Eurasia Group. "It needs to have fairly closed information flow for political stability purposes, but doing so stifles innovation."

Friedman and empiricism

John Cassidy interviews James Heckman in the New Yorker about the empiricist side of the Chicago school.

When Friedman died, a couple of years ago, we had a symposium for the alumni devoted to the Friedman legacy. I was talking about the permanent income hypothesis; Lucas was talking about rational expectations. We have some bright alums. One woman got up and said, “Look at the evidence on 401k plans and how people misuse them, or don’t use them. Are you really saying that people look ahead and plan ahead rationally?” And Lucas said, “Yes, that’s what the theory of rational expectations says, and that’s part of Friedman’s legacy.” I said, “No, it isn’t. He was much more empirically minded than that.” People took one part of his legacy and forgot the rest. They moved too far away from the data.

Bank Levy

The FT looks at the details of the bank levy

The charge will be levied on more than 20 of the largest financial institutions based on the size of their assets minus insured deposits and shareholder equity, people familiar with the matter said.

Economics

Robert Solow looks at the arguments against "free market economics" and does a very good job of outlining where rhetoric and reality lie.

Equity as state contingent securities

Chris Dillow in the Investor Chronicle
So, there's a lot wrong with the standard view. Luckily, though, there's an alternative. Don't think of shares as the discounted present value of future cashflows at all. Think of them instead as state-contingent securities that pay off different amounts in different states of the world.
So volatility can be the result of small changes in the probability attached to extreme events rather than large changes in the risk premium. More here.

Class size

The effect of university class size on performance.

We therefore estimate non-linear class size effects controlling for unobserved heterogeneity of both individual students and faculty. We find that: (i) at the average class size, the effect size is ?.108; (ii) the effect size is however negative and significant only for the smallest and largest ranges of class sizes and zero over a wide range of intermediate class sizes from 33 to 104; (iii) students at the top of the test score distribution are more affected by changes in class size, especially when class sizes are very large

Cock up or conspiracy?

Pepy's diary suggests a cock up rather than conspiracy (at his level at least).

I find the Court full of great apprehensions of the French, who have certainly shipped landsmen, great numbers, at Brest; and most of our people here guess his design for Ireland. We have orders to send all the ships we can possible to the Downes. God have mercy on us! for we can send forth no ships without men, nor will men go without money, every day bringing us news of new mutinies among the seamen; so that our condition is like to be very miserable. Thence to Westminster Hall, and there met all the Houblons, who do laugh at this discourse of the French, and say they are verily of opinion it is nothing but to send to their plantation in the West Indys, and that we at Court do blow up a design of invading us, only to make the Parliament make more haste in the money matters, and perhaps it may be so, but I do not believe we have any such plot in our heads.

Bond boom

The FT looks at financial developments over the last decade. One highlight: the boom in the bond market.

The debt markets surged not only in scale but complexity. Since 2000, for example, the amount of US bond market debt has nearly doubled in size, according to the Securities Industry and Financial Markets Association. That boom can partly be attributed to ultra-low US interest rates in the first half of the decade, coupled with an Asian savings glut, which flooded the financial system with liquidity.

In many ways this is the heart of the financial crisis. Huge international imbalances generate huge international capital flows. These capital flows, in most cases, run form central banks or other official monetary authorities through to liquid capital markets in US dollars. How could the financial sector not increase in size?

EMU

Martin Wolf in the FT highlights the structural problems with the Euro area: without fiscal and labour market mobility, pain can be intense.

This leaves peripheral countries in a trap: they cannot readily generate an external surplus; they cannot easily restart private sector borrowing; and they cannot easily sustain present fiscal deficits. Mass emigration would be a possibility, but surely not a recommendation. Mass immigration of wealthy foreigners, to live in now-cheap properties, would be far better. Yet, at worst, a lengthy slump might be needed to grind out a reduction in nominal prices and wages. Ireland seems to have accepted such a future. Spain and Greece have not. Moreover, the affected country would also suffer debt deflation: with falling nominal prices and wages, the real burden of debt denominated in euros will rise. A wave of defaults - private and even public - threaten.

A Fistful of Euros makes the same point. If the currency area is not optimal, political will is necessary to overcome pain caused by imbalances. This has already been seen in the 1980s in the UK when divergent economic conditions in the north and south caused schism. The left-leaning Labour councils in Liverpool and other northern cities seeking to stimulate their local economies could be overcome by Thatcher and the central government. Will we get the same kind of conflict between Brussels and some of the periphery governments?