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.