1. Is the European Central Bank, or maybe the whole EU, a good candidate for a Darwin Award? There doesn't seem to be a category for institutions that bring about their own demise through their own self-destructive behaviour, but perhaps there should be. In the very long run we should perhaps be thankful for dysfunctional systems' destroying themselves. But in the short run they tend to take a lot of other people and institutions down with them.
2. Is there really any difference between the fiscal policy of a Eurozone government and the budgetary policy of a household? I know it's heresy for a macroeconomist to entertain such a notion, but is there? Neither can print money, so that difference is out. Both seem to tighten their belts when interest rates rise and it gets harder to borrow, so no difference there either. And there's 17 of them, sharing the same monetary system, and any microeconomist knows that a Cournot oligopoly with 17 firms is much closer to perfect competition that to monopoly, and that 17 is much closer to infinity than to one.
3. Are Eurozone governments, on average, any riskier than Eurozone banks, on average? If any significant fraction of the governments go bust, a much bigger fraction of the banks will go bust too, I think. So does it make sense for the ECB to lend to banks at 1.25%, on loans collateralised by government bonds, even with a haircut, and not lend to the governments at anything like those terms?
4. Maybe, just maybe, a run on the Euro itself, as opposed to a run on Euro bonds, is just what the patient needs. If recessions are caused by an excess demand for the medium of exchange, then an increased risk that the medium of exchange might become an orphan currency might reduce the demand to hold it. If Euros themselves become a risky asset, even notes carefully buried in the back garden, then what are people going to buy if they decide to get rid of them? Unfortunately, it may not be investment in newly-produced real assets. Because if the monetary system collapses altogether, so there is no functioning medium of exchange and credit system to go along with it, a new factory might not be very profitable. Barter doesn't work very well.
5. Stephen Harper (Canadian Prime Minister) and Mark Carney (Governor of the Bank of Canada) have been telling the EU to solve its problems, because they fear the collapse of the Euro will affect Canada and other countries. I doubt their words had any effect, though there's no harm in trying. Other than print up 17 batches of new banknotes for Christmas presents, whether they ask for them or not, I don't think there's much Canada can do to help. And I can't think of anything Canada can really do to protect ourselves from the fallout either. Except keep our own monetary policy looser than we otherwise would, and have Export Development Canada be ready to expand trade credit on a larger scale.
6. At root, the coming Eurozone crash, like the 2008 crash, are not caused by a failure of governments, or of finance, but by a failure of monetary systems. Yes, people and governments borrowed more than they should have, and other people lent them more than they should have. But people make mistakes, and do stupid things, and loans go bad. A good monetary system should have the ability to keep the economy functioning even if loans go bad. Nowhere is it written in stone that if a lot of borrowers can't pay a lot of lenders that there has to be a recession and we all stop working and producing and buying and selling and just sit and watch while those borrowers and lenders sort themselves out.
We need a monetary system that keeps on functioning despite human mistakes, stupidity, or asteroid strikes.
Worthwhile Canadian Initiative 
Jacques René Giguère: “The markets are increasingly worried they won’t do it.”
I’m sure they will – Jürgen Stark and Axel Weber are gone, and Mercozy have just agreed to leave the ECB alone.
@K My point is that the ECB understands the difference between high yields and illiquid markets and will act when an intervention becomes truly necessary – as it has done before on multiple occasions.
.. and I think the ECB will rely on a broad definition of liquidity, which includes primary markets.
For whom? Portugal, Ireland, Greece etc are already out of the market. Italy is on the break. If you are talking about Italy then they are setting the Italy spread cap at 500. And then buying Italy here is a risk free trade. You think they are going to draw the line at Italy?
Yes, Italy and maybe Spain. Those two are too big for a Greece-style rescue package.
In any case, I wouldn’t say buying Italy is a totally risk free-trade:
– governments usually have cash reserves, so the ECB may take its time,
– and the intervention may be limited to certain maturities.
“- governments usually have cash reserves, so the ECB may take its time”
It’s still arbitrage if you are going to win eventually.
“and the intervention may be limited to certain maturities.”
So buy short end. The curve is inverted.
“I wouldn’t say buying Italy is a totally risk free”
Yes. I didn’t rush out to buy. 🙂
Sumner, I perhaps over-interpretted your agreement with Krugman and some of the other MM’ers. Thanks for clarification.
Doctor Why, perhaps you’re right. My sense, however, is that both the ECB and Merkel overestimate their ability to control the situation. There any number of political events that could spin this out of control rather quickly. I also suspect a Greece or Portugal leaving the Euro could have more effect than you seem to believe. The banking system is nearly frozen as it is, and there would certainly be no way to prevent the derivatives trades from taking effect if that happens.
Interestingly, Pettis, who cut his teeth in investment banking on the 80’s Latin debt crisis, based his call entirely on history of cross country currency unions. If the Euro makes it they’ll be the first, and given that it’s not a particularly well designed one as it currently stands that would be surprising.
I agree with Dr Why. The eurozone crisis is being overhyped – by the financial industry which has exposure to eurozone debt and would like to be bailed out, by academics who are enjoying the unwonted attention, and by a media that is increasingly sensational for a public with an increasingly short attention span. I suspect that the euro will muddle through, with some restructuring, some austerity, and a little buying by the ECB. In reality, the sustainability of euro debt and currency are different issues, and few of the eurozone public want to give up the euro, so I think that the euro will survive (and, I suspect, so does the market, which is why the euro continues to remain quite strong). I would prefer more restructuring and less ECB buying, so I think that the ECB is doing the best job of the major central banks at the moment.
K: Thank you again for your response. In your original message, it sounded like you were making the (often-heard) claim that financial markets do not need any regulation, because they are inherently efficient, equilibrium-seeking, and self-correcting, and regulations just create distortions and rent-seeking opportunities.
But in your most recent message, it sounds like you are acknowledging that financial markets are prone to market failures. But you argue that this is okay, because your new monetary system limits the damage. First, aggregate demand will no longer be affected. (There can be no such thing as
flight to security'). Second, ordinary people will no longer have any legitimate reason to trade in financial assets, since their money itself is a high-quality bundle of such assets. If they insist on playing with fire, then they can't complain about getting burned.dot com’ bubble, there was massive overinvestment in communications infrastructure (i.e. thousands of km ofThis may be so. I will have to think a bit more about whether your proposal really contains the fallout from financial meltdowns. But it certainly sounds promising.
One issue which I think your model does not address: since the supposed purpose of financial markets is to allocate resources in the real economy, inefficiencies in financial markets can translate into inefficient allocation of resources, resulting in real economic inefficiencies. Two examples: during the
dark fibre'), while during the housing bubble, there was massive overinvestment in housing construction.Efficient Markets Hypothesis’, bubbles are impossible to identify in advance, hence, impossible to prevent through regulation.Now, I grant that it is hard to imagine regulations which could prevent such overinvestment in general. After all, regulators can't see the future either. But a lot of overinvestment can be traced partly to fraud, which can be controlled through disclosure requirements (i.e. regulations). Also, a lot of overinvestment is due to the aforementioned positive feedback cycles. In your last message, you write
<blockquote>
...I think my proposal eliminates some of the worst [feedbacks]. As far as the other ones go, regulators have no special ability to counteract them. They don't see bubbles coming and are no more likely to than investors with their own money at risk. There is simply no gain from regulation here.
</blockquote>
In other words, according to the
There are two problems with this argument. First, it is not always true that bubbles are impossible to identify. One can construct models of financial markets where everyone
knows' there is a bubble in progress, but it is still rational to buy, because every trader bets that they personally can cash out before the market crashes, and leave some other chump holding the bag. Of course, there are other models where this <i>doesn't</i> happen, so this debate comes down tomy model is better than your model’. From what I have seen, however, the dynamics of financial markets is still very poorly understood, because an accurate model must have an accurate representation of the psychology of the traders, and our models of trader psychology are still 1-dimensional caricatures. So I think it is best to be suspicious of all models. But in particular, it is best not to put too much faith in models which assume a priori (or claim to `mathematically prove’) that markets are always and everywhere efficient, and speculative bubbles are logically impossible.[continued…]
[…continued]
But let’s even suppose you are correct, and bubbles are inherently impossible to identify in advance. It is still possible for regulators to put a lid on the gyrations of the financial market, by restricting leverage. Bubbles (and the inevitable crashes which follow) are hugely exacerbated by leverage. During a bubble, investors borrow against the inflated value of their assets. The more prices go up, the more they can borrow, the more they can buy, and this drives prices up further. When the market heads south, the feedback cycle reverses. Highly leveraged investors immediately start to look like credit risks. They are forced to liquidate to pay back their creditors, driving prices down further.
Even a totally blind regulator can moderate leverage cycles by imposing larger reserve/collateral requirements on investors. These centrally imposed collateral requirements must be
soft', in the sense that the investor is not required to meet them immediately, but is given some time window inversely proportional to the size of the collateral short-fall. For example, an investor might have one month to correct a 2% shortfall in collateral, two weeks for a 4% shortfall, one week for a 6% shortfall, 84 hours for an 8% shortfall, etc. (Why this schedule? If the centrally imposed collateral requirements werehard’, meaning they had to be met immediately, then they would trigger exactly the same cascade of margin calls that we see right now. That’s why they should be soft. The optimal schedule for collateral corrections would have to be determined empirically —the schedule I give here is just a crude example.)Credit default swaps are another financial instrument which could benefit even from
blind' regulation. CDSs are effectively default insurance on credit instruments like bonds or CDOs. However, unlike traditional insurance, the buyer of a CDS does not actually have to <i>own</i> the bond/CDO in question (i.e. they are not required to have what is called aninsurable interest’). This means you can buy a CDS as a way ofbetting against' a bond/CDO you don't own. Sounds like exactly the sort of instrument we need tocomplete’ the market, right? There are two problems:Because there is no `insurable interest’ requirement, it is possible to produce a `toxic’ CDO (i.e. one which is pretty much guaranteed to crash and burn), sell it, and use the proceeds to buy CDS against that very same CDO. This creates obvious perverse incentives. If you did this with a real asset (e.g. a house) it would be criminal fraud. But with a CDS, it is currently completely legal.
The total market value of outstanding CDSs on a bond issue can exceed the bond/CDO issue itself by an order of magnitude. This hugely magnifies the potential damage if the bond or CDO defaults. (This is what took down AIG).
Both these problems could be easily corrected by requiring CDS buyers to have an
insurable interest' (i.e. their portfolio of CDS must match their portfolio of credit instruments).value investing’, which involves very long-term investments.) This sort of high-frequency trading can be discouraged with a small (e.g. less than 1%) transaction tax, a.k.a.There is third way that regulators can mitigate financial market gyrations. A lot of speculative activities is correlated with traders moving in and out of markets at high frequency. (This is to be contrasted with
Tobin tax'.most’ high-frequency trading is socially positive, because it simply mops up arbitrage opportunities, thereby making price signals more accurate. I don’t understand finance well enough to take a position on either side of this argument. I am simply pointing out that the `Tobin tax’ has some fairly strong arguments in its favour.Of course, this depends on whether you think high-frequency trading is a net social positive or a net social negative. There is an argument that
There are also other ways in which regulation can improve financial markets. The last chapter of Smith’s book Econned contains some interesting suggestions, but it would be redundant to reproduce them all here.
Anyways, none of this represents a criticism of your central proposal, which I basically like. I am simply quibbling with some of your remarks about regulation.
Marcus,
Just saw your excellent comment. Will try to get back tonight.
“it sounds like you are acknowledging that financial markets are prone to market failures.”
Absolutely. I probably came across way too strong. It’s easy to err on the side of structuring your argument to appeal too much to either the left or the right, especially when there are elements that are intuitively distasteful to both. But fundamentally, conservatives are going to be more difficult to convince which is probably why I try to use their pro-deregulation bias as a lever.
First, before I address each of your points, I wanted to elaborate a little bit on a feature of my proposed system that I only passed over quickly above: that of money illusion. It seems like a minor detail but to make the importance of it really clear, imagine that we never “split” our capital asset backed money. I.e. the unit of account (to first approximation) is a fixed fraction of the total quantity of all capital assets. With this new numeraire, the total nominal value of the capital asset market never changes by construction. All we ever observe are relative price moves of different instruments. When borrowing in this money to invest, one would be short the general market and long the specific investment which really underscores the zero-sum hedge fund nature of participating in financial markets. Positive returns are alpha, not beta. I think that ought to significantly reduce the appeal of leverage which could be an important factor in protecting us from general asset bubbles.
Borrowing, as we currently see it, which involves shorting the future value of real goods, would hopefully be seen as the fairly odd inflation index derivative contract that it is. Keep in mind that there exists no asset that transports a fixed quantity of consumption into the future. Any contract that guarantees future consumption, necessarily requires someone else to short it. So if we don’t define money relative to the value of real goods then I’m hoping that we will no longer have a significant demand for fixed future consumption (currently government bonds) which can only be met by someone else shorting future consumption (e.g. a leveraged investor borrowing to buy capital assets.) So I am hoping that by breaking the anchor of money illusion to a consumption basket, that a conservative investor would simply be content to be guaranteed a fixed portion of the value of all capital assets (i.e all future consumption assuming fixed share of taxes and wages) and that the consumption basket would disappear as a relevant reference point.
As far as more specific bubbles go, I think 401k’s played a major role in fueling the dot com bubble. From 1990 to 1998 the size of 401k’s grew from $380bn to $1.5Tn which fed a steady stream of hapless online traders to the investment industry. The bubble probably wouldn’t have been prevented, but I feel like it was aggravated by this vehicle which was to a large extent the result of investment industry lobbying.
As for the mortgage crisis I think regulation did a lot of harm as discussed above. And since land value is essentially a positive externality of other peoples activities, the real solution is a Georgist style land value tax, which wouldn’t require regulators to diagnose a bubble. The tax would just kill it.
Uncovered short market CDS’s are, as far as your discussion is concerned, equivalent to a short corp, long treasury position. Again they can be manufactured in quantity so long as you have a willing seller and a willing buyer. Yes, the mechanics of borrowing bonds etc are more complex and introduce annoying funding cost uncertainty. But there is nothing radically new here. It is my opinion that short selling, whether stock, credit or whatever else is a critical part of market efficiency. The short sellers sell hard into the bubble and are the first and often the only ones brave enough to buy into the crash. If those who think an asset is over-valued cannot express their opinion, the market trades at the price at which the person who has the highest possible opinion of the future outlook will buy. That is a recipe for disaster. So I am not in favour of any kind of short selling ban.
You may know the work of Alp Simsek (and others) who demonstrates pretty convincingly that financial innovation (new derivatives) can be variance increasing for the average agent if agents use significantly different market measures. But this is a temporary effect as the long term observation of the instrument dynamics will tend to lead to a convergence in our understanding of the dynamic. So there were lots of things we didn’t know about CDS/corp/basis risk and CDO or index tranche correlation risk before the crisis which meant that people entered into bilateral trades based on very different expectations of the forward dynamic. Both parties were quite significantly surprised, but market players have much more consistent understanding of the instruments now, which improves the likelihood that they can be used to complete our real exposures and reduce rather than increase our risk.
As far as toxic CDO’s go, that was entirely the fault of the rating agencies. The CDO primary market was a giant ratings arb. The dealers would simply take the latest S&P model (which was fully available to them as a convenient spread sheet) and set out to engineer a structure that would result in the highest possible tranche ratings using the widest spread possible underlying names. This wasn’t very hard since, for starters, there was huge variation in market spread between different names of the same rating, and the agency models didn’t distinguish between an A-rated mortgage insurer and an A-rated railroad. And so on (see my previous comment).
AIG blew up because of too much credit risk. The fact that the regulators set up rules that permitted AIG to take vastly more credit risk in derivative form that they could have in cash form is yet more proof that regulators are not particularly adept. And as yet more proof that derivatives weren’t the problem, if they had taken the same exposures in cash bonds they would have blown up twice as much because of the blowout in the bond basis. I will admit however, that I don’t have a regulator free insurance industry solution. Unlike private money, people do need a private insurance market. And they certainly aren’t able to evaluate the solidity of insurance company balance sheets themselves. Alas…
“Anyways, none of this represents a criticism of your central proposal, which I basically like.”
Thank you! You and Nick, are about the only constructive feedback I have had, and I’m hugely appreciative. This debate is helping me think through a lot of issues.
Nick!
Spam filter!!!
Thanks,
K
Thanks Nick!
One more thought: If people want to use derivatives to fix future consumption (and I guess we still would as we get older) a more natural hedge would be to buy NGDP futures since that would give a claim on a fixed fraction of output rather than a fixed consumption basket.