Thursday, January 28, 2010

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.

Wednesday, January 27, 2010


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.

Wednesday, January 20, 2010

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

Sunday, January 17, 2010

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."

Saturday, January 16, 2010

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.

Friday, January 15, 2010

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.

Wednesday, January 13, 2010


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

Monday, January 11, 2010

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.

Sunday, January 10, 2010

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?


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?

Saturday, January 09, 2010

Taylor Rule

Bernanke’s Taylor rule : "Adjust the AEA chart series to take this into account and the Fed still seems to be pinned to the zero bound ie it will be a while before it raises rates unless there is a big upgrade to its forecasts. That is consistent with the guidance language on rates."

Friday, January 08, 2010

Minsky and the Fed

The Economist looks at Minsky and the Fed
The prior negligence is understandable. Not only was Mr Minsky on the fringe of mainstream economics, his core insight is antithetical to the Fed. The Fed’s raison d’etre is stability: stable prices, stable employment, financial stability. But Mr Minsky argued that economic stability encourages more risk taking and leverage, and ultimately produces more instability and bigger recessions.

Banking Risk

Another look at the BIS concerns in the FT. This highlights the dilemma for the authorities and the change in risk appetite that has taken place.

Central banks want private bankers to take more risk. They want them to lend, even if credit demand is weak. More generally, they want to see funds flow out of cash and into the real economy. That, after all, is the point of near-zero interest rate policies and quantitative easing. The result has been a colossal and lucrative carry trade, with both welcome and unwanted consequences.

It is a good point. What could be more risky than lending to a small company? What is a more complex and opaque asset that a small business loan? By contrast, government bonds, while at risk from 1994-style tightening, look relatively safe. In addition, if bond prices collapse, the subsequent losses can be blamed on irresponsible government fiscal policy.

Thursday, January 07, 2010

Carry trade

Amidst a report on a BIS invitation to bankers and monetary officials to discuss "risk-taking", there is this from the FT:
“For example, low financing costs coupled with a steep yield curve may make participants vulnerable to future increases in policy rates – a situation reminiscent of the 1994 bond market turbulence which followed the Federal Reserve’s exit from a prolonged period of low policy rates.”

This is a good example of the carry-trade and something that could be studies through the effect on the yield curve of the 1994 move towards tighter monetary conditions.

Wednesday, January 06, 2010

Bank regulation and lending

The FT reports on a study by Barclays Capital that assess the impact of new banking regulations on bank lending. The latest BIS proposals suggest that banks, particularly those that are deemed 'too big to fail', hold more capital and more closely align deposits and lending.

BarCap's expectation that regulators will cap the 20 groups' loan-to-deposit ratios at 100 per cent would mean that all banks, except the Swiss, would have to increase deposits dramatically if they are to avoid a politically damaging shrinkage of their lending. The worst hit would be Dexia, which could have to shrink lending by nearly 70 per cent, and Danske Bank, where the contraction would be 55 per cent.