Month: October 2008

Can the Fed in fact pop bubbles?

Megan McArdle wonders:

Prospectively, if you want to do it effectively, you probably need to intervene in the very early stages.  The Fed raised interest rates in the late 1920s, to no effect–indeed, it encouraged foreign capital to flow in.  Iceland’s central bank, too, tried to quiet its financial bubble, but borrowers simply ignored them–borrowed at the higher rate, or stupidly took on currency risk by getting auto loans and mortgages from abroad.  Meanwhile, more lenders were attracted by the higher rates.  If you think house prices will go up 10% every year, a 1% increase in mortgage interest rates is not really that worrying.

Do you know any good pieces on this topic?  Daniel Gross also says it is hard to do.  Here is one article on Bernanke’s bubble laboratory.

Sentences of persuasion

Are you picking Philly to make the Eastern finals?  Think again:

In a league in which you need a proven crunch-time guy to battle the
other proven crunch-time guys in the last three minutes of close games,
they don’t have a proven crunch-time guy. (And don’t tell me it’s
[Elton] Brand. I watched him for four years on the Clippers; he’s not that type
of player.) Fundamentally, this can’t work for anything beyond 45-47
wins and maybe a second-round appearance … and that’s before you factor
in the skewed level of expectations already in place, or the fact that,
again, they just spent $83 million to reunite the best two guys on a
27-win Clippers team from 2003. I just don’t see it.

I’m picking the Wizards to tank and making no other predictions.  The interesting question is whether Cleveland will deal for Allen Iverson.  Here is much more.  You’ll also find this excellent sentence:

Jamaal Tinsley is a sunk cost.

What does a credit crunch look like?

Maybe Alex is tired of this topic, if so I apologize.  But Isaac Sorkin sent me notice of this:

What does a global credit crunch look like when it comes down to raw numbers? A 3% quarterly decline in international banking activity. It doesn’t sound like much, but it represents $1.1 trillion–and that was just a snapshot taken at the end of June, before the Lehman Bros. collapse worsened the crisis in interbank lending.

It is also three times bigger than the largest contractions of the past three decades–as long as such records have been kept. After the demise of hedge fund Long-Term Capital Management in 1998, international banking activity fell by 1.2% in the fourth quarter of that year. After the dot-com bubble burst, the contraction was 1%, or $125 billion–chump change compared with today’s banking volumes.

The numbers come from the provisional international banking statistics for the second quarter of this year, released Thursday by the Bank for International Settlements, the Basel, Switzerland-based organization that acts as a lender for central banks.  BIS says most of the decline was accounted for by "short-term interbank credits in U.S. dollars," i.e., banks not lending to each other overnight–the logjam…we have heard so much about being at the heart of the credit crunch.

Note that is only from the second quarter; we’ll see what the third quarter statistics look like.  Here is the BIS link.  Note that second quarter lending was as robust as it was in part because of continued lending from Europe to Eastern Europe and also to Iceland.  That’s more reason to worry, not less.

Porsche and Volkswagen

In a time when many odd economic events are taking place, this saga nonetheless deserves comment:

Volkswagen’s shares more than doubled on Monday after Porsche moved to cement its control of Europe’s biggest carmaker and hedge funds, rushing to cover short positions, were forced to buy stock from a shrinking pool of shares in free float.

VW shares rose 147 per cent after Porsche unexpectedly disclosed that through the use of derivatives it had increased its stake in VW from 35 to 74.1 per cent, sparking outcry among investors, analysts and corporate governance experts.

This seesaw has been going on for some time and German regulators haven’t done much about it, despite complaints from hedge funds.  Today the share price rose by a factor of nearly five (!).  So for a brief while Volkswagen became the world’s largest company in terms of capitalization.  Who needs Exxon and WalMart?

I thank Ben, a loyal MR reader, for the pointer to this episode.

High interest rates

From the UK:

A consumer borrowing £100 on the card would be charged £35 in interest
on repayments of £5 a week over 27 weeks, giving an APR of 222.7%.

Is this for people who already have borrowed from the loan shark and must repay immediately or else?  Or do the borrowers simply not understand annualized interest repayments?  Of course micro-credit also involves high interest rates (in the 50-100 percent range, usually) but I can see two immediate differences.  First, micro-credit is often used to take the kid to the doctor when otherwise the outcome would be grim.  Second, micro-credit is usually marketed to the higher-IQ element in the village, not the lower-IQ element.

Addendum: Here is Virginia Postrel, defending consumer credit.

Botox makes us happy

It’s long been known that simply smiling makes people feel better and making an angry face can make people feel more angry.  Thus some cosmetic surgeons speculated:

People with Botox may be less vulnerable to the angry emotions of other people
because they themselves can’t make angry or unhappy faces as easily. And because
people with Botox can’t spread bad feelings to others via their expressions,
people without Botox may be happier too.

Amazingly, a recent experiment in the journal Cerebral Cortex supports this theory, although the abstract is a mouthful.  You can read a summary here.

We show that, during imitation of angry facial expressions, reduced
feedback due to BTX treatment attenuates activation of the left
amygdala and its functional coupling with brain stem regions
implicated in autonomic manifestations of emotional states. These
findings demonstrate that facial feedback modulates neural activity
within central circuitries of emotion during intentional imitation of
facial expressions. Given that people tend to mimic the emotional
expressions of others, this could provide a potential physiological
basis for the social transfer of emotion. 

Deflationary expectations

The difference between yields on five-year Treasuries and
five-year TIPS was a minus 0.46 percentage point at one point
this week, a record. TIPS typically yield less than Treasuries
because their principal payments rise at the rate of inflation.
A shrinking yield gap indicates investors expect inflation to

The market “is pricing in deep deflation,” said Michael
, an interest-rate strategist in New York at Barclays
Capital Inc. one of the 17 primary dealers that trade directly
with the Fed.

Here is the story

Furthermore this market price indicator, in addition to showing deflationary expectations, has implications for the nature of our current crisis.  The price of oil already has done lots of its falling.  So you might say the market expects the broader monetary aggregates — credit — to be less than robust over coming periods.  I should add (contra Alex) that a rising monetary base, without a robust credit market, won’t get you much inflation.  In fact the base has so risen because the Fed desperately has been trying to prevent…a credit crunch.  Just imagine the credit boom that the observed recent path of the monetary base would have brought if we were not in…a credit crunch.

Credit Demand and Credit Supply

We all now seem to agree that credit in the United States is actually growing during this "credit crunch," albeit at a slower rate than a year ago.  Tyler and others argue that growing credit is actually a sign of the credit crunch.  A credit crunch may show up "counterintuitively as a spike in borrowing" as firms draw on lines of credit.  Contra Tyler this view is certainly "convenient" but I do agree with him that this view is not unfalsifiable.

To wit, let’s falsify it.  The last time we had talk of a big credit crunch in the United States was during the 1990-1991 recession.  Was credit growing during this time as firms drew on lines of credit?  No.  Most of the credit measures that today are growing were in 1990-1991 flat or shrinking.  You can look at the pictures here or look at Table 1 of Ben Bernanke and Cara Lown’s well known paper (Google preview, JSTOR here).  In 1990-1991, for example  business loan growth was zero while today it is well above 10% (the same thing was true in 2001).

Peculiarly, Tyler argues that lack of credit is a leading cause of the crisis but a lagging indicator!   As a result, he needs to resort to non-verified conjectures about credit options to support the credit crunch story.  I have a simpler story, credit is a lagging indicator because it’s credit demand not supply that is the problem.  My story also makes sense of the fact that credit usually lags on the upturn as well – a fact which option value has difficulty explaining.

One error that I believe Tyler is making is to assume that skepticism about the credit crunch implies that one must be downplaying the seriousness of current economic conditions.  Not true.  First, it’s quite possible to have a very serious recession with growing credit – we had this in 82, for example.  Second, if Tyler is correct that the credit crunch is the primary cause of our current conditions then bank recapitalization should restore the economy to good working order.  In contrast, I think the Paulson/Bernanke plan is in trouble because credit demand is shrinking faster than credit supply.

Addendum: In response to Tyler (below) and several people in the comments.  Interest rates are not unusually high, certainly nowhere near as high as you would expect given a "credit crunch."  In fact, interest rates on say 30 year mortgages are falling and are lower now than at the height of the boom and no higher than in 2002 near the beginning of the boom.  I suspect that real interest rates are even lower than nominal rates suggest – inflation expectations anyone?  I wish that more people would present their arguments with data and not with anecdotes.

Credit demand and credit supply, response

I don’t agree with much of Alex’s take.  Is he suggesting that the crisis started because *borrowers* lost their appetite for loans?  If so, why in his view is the measured credit aggregate doing fine?  In terms of what really happened, the core story is that the financial systems of many countries have been hit by solvency shocks, some credit markets (not all) have frozen up, we have zombie banks, asset prices tank, and now yes the demand for credit will be going down as well. 

Does Alex deny the "solvency shock"?  Or does he think you can have such a shock without some credit markets freezing up?  His post does not tell us but I find either position extremely implausible.

By the way, LIBOR and many other interest rates are rising, not falling; that is not what you would expect if falling credit demand were the key problem.  Nor does Alex mention the "shadow banking system," a core part of the current disintermediation.  There is no way to explain away what is happening there and of course that is not counted in the aggregates Alex consults.  There also has been a massive liquidity scramble in some sectors which again is inconsistent with falling credit demand as the problem.

The current punishment of the banking system goes far beyond the early 1990s; today’s credit crisis is driven by insolvency and potential insolvency but the 90s did not devastate finance or anything like that.  And I’m not especially sanguine about bank recapitalization, as I’ve indicated in numerous posts to date.  For one thing, politicization has its own costs but more importantly there is no guarantee that recapitalized banks will lend on the appropriate scale.

I can at least say with confidence that either Alex or I is totally wrong on this matter.

Why the market has been down on the Euro and European banks

Austria’s bank exposure to emerging markets is equal to 85pc of GDP
– with a heavy concentration in Hungary, Ukraine, and Serbia – all now
queuing up (with Belarus) for rescue packages from the International
Monetary Fund.

Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for
the UK, and 23pc for Spain. The US figure is just 4pc. America is the
staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America,
almost twice the lending by all US banks combined ($172bn) to what was
once the US backyard. Hence the growing doubts about the health of
Spain’s financial system – already under stress from its own property
crash – as Argentina spirals towards another default, and Brazil’s
currency, bonds and stocks all go into freefall.

Broadly speaking, the US and Japan sat out the emerging market
credit boom. The lending spree has been a European play – often using
dollar balance sheets, adding another ugly twist as global
“deleveraging” causes the dollar to rocket. Nowhere has this been more
extreme than in the ex-Soviet bloc.

The region has borrowed $1.6 trillion in dollars, euros, and Swiss
francs. A few dare-devil homeowners in Hungary and Latvia took out
mortgages in Japanese yen. They have just suffered a 40pc rise in their
debt since July. Nobody warned them what happens when the Japanese
carry trade goes into brutal reverse, as it does when the cycle turns.
. . .

Just in case you were wondering.  Here is the link.  By the way, this is further evidence that the driving force behind the earlier boom was the global savings glut, and sheer giddiness, not the excessively loose monetary policy of Greenspan’s Fed.  The ECB has pursued a relatively tight monetary policy since its origin.  It also will be interesting to see what trouble arises in Spain, since Spanish banking regulation has been considered a model of how to keep these problems under control.

And here’s Romania fact of the day:

Romania raised its overnight lending to 900pc to stem capital flight…

Mark to market for Social Security?

Why not, I say?

Implicit government obligations represent the lion’s share of
government liabilities in the U.S. and many other countries. Yet these
liabilities are rarely measured, let alone properly adjusted for their
risk. This paper shows, by example, how modern asset pricing can be
used to value implicit fiscal debts taking into account their risk
properties. The example is the U.S. Social Security System’s net
liability to working-age Americans. Marking this debt to market makes a
big difference; its market value is 23 percent larger than the Social
Security trustees’ valuation method suggests.

Here is the paper, by Alexander W. Blocker, Laurence J. Kotlikoff, and Stephen A. Ross.  Here is an ungated version.  Do note that a worsening crisis will increase the magnitude of this difference.