Monthly Archives: July 2007

The great normalisation again

The normalisation of the two global asset market anomalies of the period from 2003 to QI 2007 – very low long-term risk-free real interest rates and astonishingly low credit risk spreads across the board – is proceeding apace. Long-term risk-free real rates are no more than about 50 bps from their long-term historical average – certainly if we filter out the transitory flight to quality that has temporarily boosted government bond prices for the past few weeks. Default risk premia on corporate debt, and on the debt of any institution exposed to the US subprime mortgage market are almost back to normal. Credit spreads further removed from the subprime debacle are still low, including emerging market debt of countries that don’t have foreign exchange reserves coming out of their ears (there are some!). What is interesting is that global stock markets have gone through a non-trivial, albeit still modest, downward adjustment in the last couple of weeks, and especially at the end of last week. Such a correction is quite consistent with the often-heard view that, compared to debt and credit default risk , that is, given then prevailing long-term interest rates and credit risk spreads, equity was not overpriced during the asset anomaly period. All that statement means, after all, is that the price of equity seemed reasonable, in that it could be explained in terms of the three key fundamentals: projected future earnings, risk-free discount rates and a reasonable guess at the equity risk premium. There was no need to rationalise equity valuations as the result of a bubble in the stock market. However, even if there was no bubble in the stock market, equity could have been the beneficiary of a bubble in the bond markets, and even of the credit risk market anomaly, if the equity risk premium responded to the same force(s) that kept the default risk premium artificially low. A fall in the stock market is, in fact, quite easily rationalised as a result of the fundamental shocks that caused weakening of the two asset market anomalies. Even if the anticipated future path of earnings were unchanged, the bursting of the bond market bubble that, in my view, caused almost of the increase in longer-term risk-free discount rates, would have a negative impact on equity values through an increase in the risk-free component of the equity earnings discount rate. It is true that higher default risk premia caused by a sudden reduction in risk tolerance (an exogenous shift towards fear on the greed – fear spectrum) does not necessarily imply a higher equity risk premium. It is, however, not difficult to come up with quite plausible stories that would have credit risk premia and the equity risk premium going up in tandem; for instance, an increase in risk aversion, holding constant the covariance between consumption growth and the return on equity, would do the job. Finally, expected future earnings growth could have been revised downwards, either independently of the shocks causing the two asset market anomaly corrections or (partly) as a result of these same shocks. There is, however, no evidence, either aggregate or at the level of individual corporate earnings reports, of any unexpected weakness in corporate earnings. Three key global asset market now have flashing amber lights. Does this mean we are about to see the end of the five golden years that saw global real GDP growth never far below 5 percent per annum? Possibly but not likely. The fourth (set of) key global asset price(s), exchange rates, are continuing to play a stabilising role. The US dollar is tanking, as it must. The yen is finally strengthening, as it ought to. The euro and sterling are strong as a DDR body builder on steroids (there is some redundancy in this simile), but there seems to be remarkably little pain. While we may seem some weakening of real economic activity in the remainder of 2007 and in 2008 relative to what was expected earlier (pace the IMF which just revised its forecasts for 2007 and 2008 upward), I believe it more likely that we will continue to see a lot of Sturm und Drang in global financial markets, especially in the overdeveloped world, but rather little noticeable weakening of real economic activity. The financial superstructure appears increasingly to exist in a world of its own, cocooned off from the rest of the world. Fortunes are won and lost, but except for those immediately affected, it really does not impact much on anything real, that is, on anything that matters. This in not what economic theory tells us, since all asset price changes have distributional effects which ought not, in general, to ‘wash out’ as regards their effect on aggregate demand. In addition, changes in the prices of ‘outside’ assets (real capital, land etc.) have aggregate wealth effects which should affect the demand for currently produced goods and services, but it is darn hard to see much evidence of this most of the time.

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A little-known fact about the ECB It is a remarkable but little-commented-upon fact that, despite the UK not being part of the Eurozone, the ECB has been located in London since its creation. Even more surprisingly, its headquarters are at Lord’s, the home of cricket.

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Taming Sovereign Wealth Funds, Again Peter Mandelson, European Commissioner for External Trade, has pondered aloud whether the perceived threat of Sovereign Wealth Funds buying up controlling interests in strategic or ‘sensitive’ sectors might be countered by reviving the use of the ‘golden share’. A ‘golden share’ in an enterprise gives the government that holds it the right to veto strategic decisions involving the enterprise, including its falling into the clutches of an undesirable new owner. If the cure is not to be worse than the problem it aims to correct, the wielding of the golden share by national governments in the EU should always be subject to approval by the European Commission. That way we avoid the risk that golden shares will be used for national protectionist purposes, the creation and defense of national champions and other continental Colbertist voodoo. It would not, of course, eliminate the risk that the Commission could abuse its role in the golden share process to pursue a protectionist strategy at the level of the EU and to create European champions. While there is little chance of that happening with the current crop of Commissioners, who are about as market-friendly a bunch as Brussels has ever seen in one place, that could change when the incumbents turn over in the key directorates of Competition, Internal Market, External Trade, Transport and Energy . A further safeguard would be to allow all those who fall foul of the exercise of the new golden share the automatic right to appeal to the European Courts of Justice. If the ECJ too were to become Euro-protectionist, it would be time to think of emigrating.

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When living is a fate worse than death; the case for voluntary euthanasia

Too many people I cared for have died before their time, killed by cars or cancer. Too many others have lived well beyond their time. With the progress of medicine and the widespread increase in longevity, the second category is likely to increase relative to the first. The issue is not, however, a new one. Job 42:17 reads: “So Job died, being old and full of days”. The Dutch version is rather more direct: Job dies “oud en der dagen zat.”, which is best translated as ‘old and over-filled with days’. The word ‘zat’ – related to ‘sated’ and ‘satisfied’ – has a strong connotation of too much of a good thing. In Afrikaans, the characterisation is ”old and ’lived out’” (‘afgeleefd’).

The three grandparents I got to know well all went through an absolutely dreadful final two years of life – all three were in their eighties when they died. When I say dreadful, I mean dreadful for them, and not just for those who loved them and witnessed their humiliating and undignified decline into pain, incontinence and incoherence laced with flashes of understanding, despair and horror at what was happening to them. The problem of living too long has now reached my parents’ generation. Some day (if I am lucky enough to live that long) it will be my problem too. Unlike my grandparents and my parents, I intend to be ready when that day arrives. Unfortunately, my proposed course of action would be illegal under the laws of most countries (the enlightened Netherlands are an exception), including the UK and the USA. Were I to require assistance to carry out my plan, the person(s) assisting me could be tried for manslaughter or murder.

Here is my position:

Suicide is a fundamental human right. Assisting someone to commit suicide should, subject to proper safeguards and oversight, be legal.

It is clear to me that the right to commit suicide must be restricted to adults who are of sound mind and who are not suffering from treatable but untreated forms of clinical depression. Assisted suicide should, as it is in the Netherlands, be supervised and accompanied by qualified medical personnel, and be subject to clear guidelines and judicial oversight and accountability.

There are risks associated with assisted suicide and voluntary euthanasia. The main risk is that voluntary euthanasia becomes euthanasia (‘good death’) in the eyes of the just the party or parties administering it rather than in the eyes of the person seeking to end his life. From that point, it is but a small step to involuntary euthanasia or murder. Getting the doctor to quadruple granny’s morphine dose to get at the inheritance in time for the summer holidays, is not part of the package. It is therefore essential that full, informed consent be given by the person wishing to end his life, without any external pressure. Only an adult of sound mind, not blighted by treatable but untreated clinical depression, can make the determination to end his life. This means that those in a coma should be kept on life support, unless they have left clear instructions, say in the form of a notarised living will, that they are not to be kept alive under such circumstances. It may be sensible to make it mandatory for all adults to have living wills covering these contingencies.

I believe that these views on suicide and assisted voluntary euthanasia are fully compatible not just with enlightened humanist ethics, but also with the fundamental tenets of the Christian faith I grew up in and confess to this day. I can see no conflict or tension between my views and the moral imperatives emanating from the two great commandments, quoted by Christ from the Books of Moses: “First, you shall love the Lord your God with all your heart, all your soul and all your mind; and, second, you shall love your neighbour as yourself”.

We have no say in how and when we enter this world. We can have a say in how and when we leave it. That freedom – the right to choose and, if necessary, the right to die, and to choose the time and manner of our dying – is a gift of God – a precious gift.

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The Great Normalisation Following the collapse of the tech bubble, the past 5 years or so have been characterised by two global asset market anomalies: low long-term risk-free real interest rates and very low credit risk spreads (or default risk spreads) of all kinds. High-grade sovereigns paid only slightly lower rates than potential fiscal flunkies, both within the industrialised world (e.g. Bunds vs 10-year Italian or Greek sovereign debt) and comparing advanced industrial countries with emerging markets; corporates paid surprisingly small spreads over their sovereigns; even junk – non-rated instruments – was cheap. Many explanations were offered. Low risk-free real rates were the result of an ex-ante saving glut driven by the high saving propensities of some of the BRICS (Brazil, Russia, India, China, South Africa – the leaders of the new industrialising countries – the acronym invented by Jim O’Neill of Goldman Sachs) and of the commodity exporters that were (and are) the major beneficiaries of the terms of trade windfall that characterises this phase of the globalisation process. In addition, Caballero has argued that in many of the fastest growing emerging markets and other high-saving countries, there has been a relative scarcity of low-risk financial instruments, because of the lack of governance and weakness as regards the rule of law in areas like contract enforcement, creditor protection and minority shareholder protection. This has further depressed the yield on securities issued by those borrowers (especially the governments of the US and the Euroland member states) that were deemed capable of committing to the rule of law and of foreswearing discretionary default. While there may be something to these stories, there remains in my view a large unexplained ‘real risk-free rate gap’ – a long-term interest rate bubble, if you want – up until, say, six months ago. The explanations of the low credit risk spreads were almost all parial equilibrium at best, spurious at worst. Many had a ‘New Paradigm’ flavour. Whenever you hear the words ‘New Paradigm’ as an explanation for why things are really different this time around, it is time to take out the bullshitometer for some careful measurements. The proliferation of new contingent claims, especially CDOs, CLOs and CMOs, and of new financial institutions willing to issue and/or hold these claims, meant that previously illiquid bank loans and household mortgages could now be securitised and sold off. By assigning the receivables from the pool of underlying assets (say, mortgages) to ‘tranches’ of securities with different seniority, a pool of receivables whose average quality was ‘regular junk’ could support some tranches with higher credit ratings as well as, inevitably, an ‘unspeakable junk’ tranche. The theory was that this proliferation of instruments and institutions for repackaging, slicing up and reselling credit risk, would lower the average credit risk spread required for a given amount of fundamental default risk to be held. Nice theory. Just two things wrong with it. First, the total amount of fundamental default risk that needs to be held could well increase when another set of financial intermediaries (issuing new financial instruments) comes on the scene. Second, there is no reason to believe that, whatever the total quantum of undiversifiable risk that needs to be held, it will be held by those best able to bear it. First, the possibility that an increase in the number of institutions and instruments could increase the total amount of risk that needs to be held. When the the chain of financial institutions and instruments interposed between ultimate savers (households, corporations and governments) and ultimate investing entities (non-financial corporations and governments – sometimes households also, although our accounting conventions do not classify this as capital formation), gets longer, not only does the pool of potential risk sharers get larger, but the number of transactors and transactions subject to counterpary risk increases. The likelihood of default occurring somewhere in the chain therefore may well increase. Second, the possibility that risk ends up being held by the wrong parties. Just because today financial engineering permits contingent payment streams to be broken down into what some call ‘their most fundamental pieces’, does not mean that risk now really ends up with those most able to bear it. The same financial engineering techniques permit risk to be bunched and bundled in ever more convoluted ways. The risk still ends up with those most willing to bear it. Whether they are also most able to do so, only time will tell. New contingent claims that can be used to hedge risk can equally well be used to seek out and take on risk that without these new instruments could not have been bought and held

The past couple of decades has witnessed developments that have exacerbated two long-standing sets of problems in the trading of risk. The first is that the pace of product innovation in financial markets, both in exchange-traded instruments but especially in the over- the-counter (OTC) market where designer financial engineering is rife, has outstripped our capacity to understand, let alone price these products. Nor have regulators and supervisors kept up.

Some of these structured finance products are so complex that even their designers probably don’t know what risks are embedded in them. Financial institutions that hold these instruments cannot mark them to market because there is no liquid market for them (this holds even for many CDOs that are, in principle, exchange-traded instruments). Instead they are frequently ‘marked-to-model’, using models whose complex mathematical and computational features neither the institution’s risk managers nor the supervisor/regulator (if there is one) have mastered. Alternatively, they are valued on the basis of quotes from brokers that do not have to deal at the prices they are quoting; such cheap talk is completely meaningless, even when the parties making them have the proper arms-length relationship with the holder of the securities. At times, they are priced using some wet-finger-method based on the credit rating of the instrument, even through these ratings are provided (sold?) by agencies that are too often conflicted and/or far too close to the designers and issuers of the instruments. For illiquid AAA-rated CDOs, it was until recently common practice to value them at par. Of course, even true AAA-rated instruments can be subject to considerable market risk. This market risk can become default risk for the counterparties of the party holding the AAA-rated instrument subject to the market risk.

Not only don’t we know how to price many of these instruments, we often don’t know who ends up holding them because of inadequate reporting obligations for many systemically important institutions. Basel II, with its emphasis on ‘marking to market’ is encoutering the problems of there not being markets for a growing number of newly designed instruments (as well as for the remaining old illiquid instruments), is clearly fighting the wrong war. Marking-to-model is an invitation to deceit, fraud and corruption.

The second problem, highlighted by both is that increasing numbers of financial institutions operate across many different national jurisdictions. Supervision and regulation are organised at the national level. Cooperation and coordination attempts are forever chasing new institutions and new instruments. One can only hope that the development of EU-wide supervision and regulation of financial institutions and markets will permit a significant reduction in the number of ad-hoc arrangements that needs to be concluded.

The problem of global financial markets and global financial operators running circles around national supervision and regulation is aggravated by regulatory competition between nations, which often makes for a race to the bottom, with minimal regulatory and supervisory demands being made on systemically important financial institutions. Many, including most hedgefunds and private equity funds, have at most rudimentary reporting obligations.

When even self-regulation (which really means no regulation at best, and at worst no regulation plus cartelisation of the industry) is considered too onerous, and when voluntary codes of conduct are sniffily rejected, it is clear that we have created and informational black hole and an increasingly under-regulated financial system where no-one knows who owes what and to whom.

All this is a long if not long-winded way of saying that global default risk premia went down, across the board, to ridiculously low levels despite there being no obvious change in the determinants of default risk and in the fundamental price of default risk. We had a default risk premium bubble – an explosion of default risk euphoria. Both global asset market anomalies are being reversed. Long real risk-free rates are almost back to normal. Temporary episodes, like the ‘flight to quality’ we saw last week, may depress real risk-free yields for a bit, but there is no doubt that the UK will not see a real yield of 0.38 percent on 50-year index-linked gilts again any time soon. There is perhaps another 50 bps to go still, at the ten-year maturity, but normalisation has taken place. And this appears to have happened without damaging the remarkable expansion of the global economy. What triggered the real rate normalisation? Some observers point to the reduction in the saving rates of the oil exporting countries. My view is that since the extraordinarily low real rates were not a fundamental but a bubble-driven phenomenon, the bursting of that bubble does not require a fundamental explanation. Credit risk spreads are also being normalised. Starting from the US sub-prime mortgage derivatives markets, corporate spreads have increased throughout the industrialised world, especially in the financial sector where most of the suspect financial claims are likely to be held. Covenant-lite bonds and loans, another manifestation of low spreads in a qualitative dimension, are no longer finding takers at any yield borrowers are willing to offer. There is quite a bit more to go as regards credit risk spread normalisation, however. Emerging market spreads, for instance, still look unrealistically low. It’s true that most emerging markets are far removed from the US sub-prime housing loan markets and the CDOs and CMOs issued against them, but it is an error to believe that a repricing of credit risk was required only in the CDO and CMO markets and for the institutions exposed to them. The blow-up of the US sub-prime housing market, of the financial instruments based on them and of the hedge funds invested in them, was indeed the event that triggered the renormalisation of global credit spreads. But even without the sub-prime housing loan scandal, global credit spreads seriously underpriced global default risk. The US sub-prime debacle is a classic example of a ‘fin-de-credit-boom’ loss of discipline, judgement and control. On the demand side for mortgages issued to customers with impaired credit histories, there were growing populations of crooks and ignoramuses. On the supply side, greed, lack of memory and lack of internal control by banks and other mortgage lenders permitted the proliferation of utterly inappropriate instruments such as interest-only mortgages and negative amortisation mortgages. Asking for income verification was considered superfluous. Finally, the regulators dropped the ball completely, and should pay the price for this failure of regulatory and supervisory oversight. To witness the Fed, having failed to prevent the issuance of ludicrously inappropriate mortgage instruments to known bad credit risks, now engaged in populist ‘leaning on the lenders to go easy on the non-performing borrowers’, is shameful indeed. The normalisation of credit spreads, especially in emerging markets, still has some way to go. However, its impact on the real economy, admittedly an exercise blighted by the need to come up with a convincing counterfactual, appears thus far to be minor at most. This would be what one would expect, if the increase in spreads reflects a repricing, due a bursting bubble, of given fundamental determinants of credit risk, rather than a worsening of the determinants of credit risk. One area of vulnerability remains the US. A history of financial excess, encouraged by regulatory failure, has resulted in greater vulnerability to a further repricing of credit risk than elsewhere in the industrialised world. The housing market is tanking. Growth has slowed to a rate well below potential, and there is considerable downside risk (as well as significant upside risk) to the 2.5 -3.0 percent growth forecasts that represent the Fed’s central scenario for the next year and a half. There is a material risk that the combination of the normalisation of the two global asset market anomalies, together with a significant further slowdown in the US, would trigger a global slowdown, bringing to an end the halcyon semi-decade we have just experienced. The other area of vulnerability is China. Runaway growth (now 11.9 percent at an annual rate) and rising inflation (CPI inflation at 4.4% at an annual rate) point to an unsustainable credit boom. It is also becoming increasingly obvious that China’s growth rate and growth pattern is utterly environmentally destructive and unsustainable. The risk of a combined credit crunch and environmental emergency is real and rising. No doubt the monetary authorities in the US and elsewhere would respond of the global business cycle were to turn down. The Fed, with its triple mandate, would cut rates more aggressively than the ECB and the Bank of England, with their lexicographic or hierarchical inflation targeting mandates. The Bank of Japan, still with one leg in the liquidity trap quagmire, could not do much. China’s monetary authority is not yet a full domestic player, let alone a global player, and would not be able to make a material contribution to the management of the global business cycle. It need not happen. It is not yet my central forecast. But the likelihood is growing of a slowdown in global economic activity, prompted by the normalisation of the two global asset anomalies, a serious slowdown in the US and a growth implosion in China. For the first time in five years, the global growth light is turning from green to amber.

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Carbon Offsets: Open House for Waste, Fraud and Corruption

The UK House of Commons Environmental Audit Committee wants to compel airlines and other “carbon-intensive” businesses to offer customers the means to offset their environmental impact.

Presumably they would do this by forcing these businesses to buy more offsets in the carbon offsetting market, which is predicted to be worth at least £4 bn a year by 2010.

Like politicians everywhere, the Environmental Audit Committee, when diagnosing the presence of a problem, look for a solution that will involve preferably no visible price tag at all, and in any case no price tag that can be traced to them.

If excessive CO2E (carbon dioxide equivalent greenhouse gas emissions) are a problem, there are but two solutions. The first is command-and-control methods: limit the scale of the activities creating excessive CO2E emissions by administrative or regulatory fiat. In the limit, ban them. This was done with chlorofluorocarbons (contributors to the ozone hole over the Antarctic) which were phased out by 1996. It can be effective if something is to be banned completely. That is not possible with CO2E emissions. Any conceivable future will have continued emissions of CO2E. Bureaucrats are not very good at deciding who can produce how much CO2E in hundreds of thousands of activities and firms. Last time something like that was tried we called it Central Planning.

The second way to reduce CO2E emissions is to make it more expensive at the margin to engage in the activities/processes that produce CO2E. By increasing their marginal cost to the producer using the CO2E-intensive process and to the consumer engaged in CO2E-intensive activities, an incentive to economise is created. This can either be done through, you guessed it, taxes on production processes and consumption activities that produce CO2E or through ‘cap and trade’.

With explicit taxation, the authorities set the tax rate per quantum of CO2E emitted at the level expected to achieve the desired level of (and reduction in) CO2E emissions. With cap and trade, the authorities determine the upper limit or quota on the amount of C02E emissions that will be allowed in a given period. They create permits to issue that amount of CO2E and either give them away or auction them off. If they are given away, there has to be an efficient secondary market in CO2E emission permits for the scheme to have any effect.

In a world without uncertainty, the competitive price of a permit for a given quantity of CO2E emissions under cap and trade would be the same as the tax paid on that quantity of CO2E emissions under explicit taxation. In a world with uncertainty, they are similar but not equivalent; neither one obviously dominates the other under all circumstances. Politicians, including Gordon Brown, prefer cap and trade, because it hides/obscures the fact that for it to work, it must be equivalent to a tax; however, it does not look like a tax and will not show up in conventional tax burden calculations. Also, you can hand out the credits free of charge to your friends (including the heavy historical polluters).

A first-round give-away does not necessarily reduce their effectiveness of cap and trade in reducing CO2E emissions, as long as the permits can be resold on an efficient secondary market. With such a market, a heavy polluter (who will have to retain most or all of its free allocation rather than selling them at a profit to other polluters) remains confronted with a higher opportunity cost of CO2E emissions at the margin. However, compared to the government auctioning the permits off to the highest bidder, giving them away is a lovely device for making lump-sum wealth transfers to the government’s friends.

Command-and-control methods, taxation and cap and trade all have the same informational requirements: the authorities must be able to monitor the quantity of CO2E actually emitted. That is no small task in many instances, which is why taxes and cap and trade tend to focus on the biggest emitters only. Sometimes it’s easy. A CO2 tax can be added onto the regular fuel tax to encourage lower CO2E emissions in transportation using petrol or diesel fuel.

Offsets, the creation of credits that can be added to the (national, regional or global) CO2E quota under cap and trade schemes, require not only the (difficult) verification of how much CO2E is actually emitted in the real world, but also the impossible verification of how much CO2E would have been emitted in some counterfactual alternative universe. The quantity of offset credits earned by some activity is the net quantity of CO2E that has been saved as a result of this activity.

Just stating it makes one shout out: impossible! Fraud! Bribery! Corruption! Wasteful diversion of resources into pointless attempts at verification! And indeed this is what is happening before our eyes. Enterprises get paid for not cutting down trees and for installing filters and scrubbers they would have installed in any case. The new Verification of the Carbon Counterfactual industry is growing in leaps and bounds. The amounts of money involved are vast and the opportunities for graft, bribery and corruption limitless. The offset proposal has birthed a monster.

Who came up with this demented offset concept? It’s an attempt to placate the developing world for not having enough CO2E emitting activities historically to benefit from a significant free initial allocation of credits in proportion to a country’s historical track record of CO2E emissions. If we had a common worldwide tax (say a constant real amount per unit of CO2E emissions), nobody would have thought of offsets. If the UN were the only source of carbon credits, and if it were to auction the entire quota each period in a single, transparent global auction, no-one would have come up with this ludicrous offsets concept. It is because countries were awarded free CO2E quotas under the Kyoto Protocol and under subsequent EU schemes in proportion to their past CO2E emissions, that we found former heavy polluters like Russia with permits that were surplus to requirements, but poor newly industrialising countries like Vietnam with very little by way of free initial allocations. So we had to do something for the historically CO2E emissions-innocent developing world. What was chosen was the most real resource-wasting and corruption- and rent-seeking inducing scheme anyone could think of. Masses of jobs for engineering consultants, environmental auditors, lawyers etc. All verifying the unverifiable and getting paid handsomely for it.

If we want to help the developing world to install CO2E efficient technology and to discourage CO2E-inefficient production, transportation and consumption, we hould encourage these poor countries to tax these CO2E-intensive activities; we should then send them unconditional cash to take care of the distributional and poverty consequences of the higher CO2E taxes. That, however, would mean higher taxes in the rich countries, or lower public spending in rich countries. And God forbid that reducing CO2E emissions would have a visible price tag. Truth, courage and politics: three concepts almost never encountered in the same place.

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Response to a comment by Waltraud Schelkle on my Fed2 post

My argument does not depend on there being a structural break in the relationship between headline inflation and the difference between non-core and core inflation – that is a break since about 2002 in the relationship shown in Chart 2 of the Fed2 post. It is rather about a break in the time-series process governing the relative price of non-core and core goods – to be precise, greater persistence, since about 2002, in the difference between the inflation rates of non-core and core goods. The fact that headline inflation tends to be higher when non-core inflation exceeds core inflation (that is, when the relative price of non-core goods is rising), need not imply any bias towards higher or lower headline inflation over time than would have been the case with a constant relative price of non-core to core goods. There would be no such bias if an increase in the relative price of non-core to core goods one period tended to be followed by a decrease of comparable magnitude during the following period(s). It so happens that the acceleration of globalisation at the beginning of the century has led to a rather long sequence of years in which an increase in the relative price of non-core goods to core goods has been followed by a further increase in the relative price of non-core goods to core goods. While this process of a rising relative price of non-core to core goods will not last forever, it is likely to have ‘legs’ for at least another decade or so (this medium-term pattern will of course be reversed temporarily if there is a cyclical downturn in global demand). So the structural break was in the relative price process of non-core and core goods – in Chart 1, not in Chart 2. Even though it is not essential to my argument, it is interesting to check whether there is visual evidence of a break in Chart 2 as well. Unfortunately, I haven’t figured out yet how to colour the post-2002 observations in Chart 2 differently from the earlier ones, as you suggested. So instead I offer here two Charts (Chart 3 and Chart 4). Chart 3 has the 1987M1 to 2001M12 observations from Chart 2 of the Fed2 post, and Chart 4 has the 2002M1 to 2007M4 observations from Chart 2. It does indeed look as though the relationship has become somewhat stronger (i.e. the curve is steeper in Chart 4 than in Chart 3). That would be icing on my cake, but the cake would be pretty good even without it.
Chart 3
Chart 4

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Taming Sovereign Wealth Funds in Two Easy Steps

Sovereign Wealth Funds are big and getting bigger. Morgan Stanley estimates that assets under management currently amount to about $2.5 trillion. Within five years, SWFs could manage funds larger than the current global stock of foreign exchange reserves (about $5 trillion). By 2015, they could collectively manage $12.5 trillion. A trillion here, a trillion there – pretty soon you are talking real money.

The distinction between official foreign exchange reserves, which are historically invested in highly liquid and safe instruments, generally of short maturity, typically managed by central banks, and state investment assets managed by SWFs, which can be invested in anything, from portfolio equity, to Blackstone, infrastructure and pork bellies, is hazy and not terribly important. Unless a country is committed to a fixed or crawling peg for the indefinite future, true reserves will be very small. Most of the $1.1 trillion still held as ‘reserves’ by the People’s Bank of China, represents in reality excessively cautiously invested SWF assets, even though the PRC appears committed to a de facto crawling peg for the Yuan for the foreseeable future.

Some of the individual funds are pretty big as well. The Kuwait Investment Authority (KIA) is estimated to hold in excess of $500 billion of assets. The Norwegian Government Pension Fund – Global (popularly known as the Petroleum Fund), holds around $333 bn; the Government of Singapore Investment Corporation Private Limited (GIC), which manages the country’s foreign exchange reserves, and therefore is not a SWF in the strict sense, has $100 bn under management. The investment arm of the Singapore governments, Temasek Holdings, has assets of $65 bn of which 25% is currently invested abroad – a fraction expected to increase to 66 percent in due course. The China Investment Corporation has assets worth $200 bn, and the People’s Bank of China still sits on ‘reserves’ in excess of $ 1.1 trillion (and rising). The Oil Stability Fund of Russia currently has assets worth $75 bn. In addition, the Central Bank of Russia sits on foreign exchange reserves of well over $200 bn. Saudi Funds amount to $300 bn.

Does any of this matter? It matters for two reasons.

First, if and to the extent that these SWFs are large enough to be systemically important, a failure by one or more of them – or even a significant loss suffered by one or more of them – could drag a significant number of counterparties into the abyss and thus endanger financial stability worldwide.

Second, since these funds, even when privately managed, are owned by the state and therefore controlled by the state, they could be motivated by non-commercial considerations in their transactions and investment decisions. As agents of the state, these funds are always potential instruments of foreign policy, supplementing conventional diplomatic and military methods for putting pressure on other states. Since many of the largest SWFs are controlled by governments that range from authoritarian to totalitarian, not to say nasty, one cannot view their investment decisions in the same way as the profit-motivated investment decisions of private investment funds and other private investors.

The solution to the first problem is openness and transparency. At the moment, most of these funds – the Norwegian Oil Fund is a notable exception – are as transparent as mud. We don’t know what they have on their balance sheets and what they have invested off-balance sheet. We don’t know anything about how much capital they hold, about their reserves, the liquidity, maturity and currency composition of their investments, their leverage etc. etc. We also don’t know to what extent their owner (the state) is willing and able to stand behind them financially were they to hit trouble.

Governments and regulators of countries whose residents issue financial instruments that are likely targets for SWFs should only allow the SWFs to acquire these instruments if the SWFs provide sufficient regular, independently audited information about their balance sheets, other exposures and investment strategies. Of course, we don’t today require much transparency and independently verified information either from certain privately owned investment vehicles, like hedgefunds and private equity funds. The more demanding reporting obligations I recommend for SWFs should be applied to privately owned hedgefunds and private equity funds as well.

As regards the second problem, the risk of political extortion by a foreign state-owned investor is greatest with equity investments. The risk is not altogether absent in the case of investments in fixed income instruments and other financial instruments that don’t have equity-type control rights attached. Creditors and bond holders have statutory rights that could be exercised in a way that is disruptive for the issuer of the instruments. And, provided they are willing to take a capital loss, large holders of a country’s debt (say the PRC as one of the two largest holders of US Treasury bonds), could threaten to dump them on the market, driving US rates up sharply, unless certain political concessions are made.

Ordinary equity however, gives control rights as well as rights to the residual income of the entity that issued the equity. This creates a real problem. No UK government would or should accept a situation where the Russian Oil Stability Fund buys control of some strategically important gas or power distributor in the UK, let alone of key bits of the pipeline system or grid. It would be equivalent to selling these assets to Gasprom or directly to the Kremlin. Since the Russian state has already chalked up quite a record – in Ukraine, Moldova, Turkmenistan, Belarus and other countries in Central Asia – for using Gasprom as an instrument of Russian foreign policy, the Russian Oil Stability Fund can never be trusted to act as a normal profit-driven investor.

The solution is simple. SWFs should only be allowed to invest in equity that does not have control rights attached to it, that is, non-voting stocks and shares.

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The Fed still hasn’t recovered the plot: core vs. headline inflation again

Oh boy…

Let me quote from the Testimony of Chairman Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress, before the Committee on Financial Services, U.S. House of Representatives July 18, 2007

“Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months–both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first five months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability (footnote in original: Despite the recent surge, total PCE inflation is 2.3 percent over the past twelve months). Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months, with core PCE inflation coming in at an annual rate of about 2 percent so far this year.”

Here we have the Chairman of the Fed reassuring us that inflation is under control because, when you strip out the items in the price index with the highest inflation rates, the inflation rate of the remainder is only slightly above target.

It is indeed true that food and energy prices tend to be quite volatile. Chairman Bernanke, however, makes at least two logical errors in going from that defensible empirical assertion to the conclusion that core inflation may be a better gauge than overall inflation (headline inflation) of underlying inflation trends. First, volatile food and energy prices don’t necessarily imply volatile food and energy price inflation. If successive values of highly volatile (logarithms of ) core price levels were negatively correlated, core inflation rates could have low volatility. No former academic economist should miss an opportunity to remind (or explain to) the great unwashed the key distinction between levels and changes, between high, rising and accelerating. It is disappointing to see someone with Chairman Bernanke’s background waste an opportunity to strike a blow for conceptual hygiene. In this case, only general harm is done – a didactic opportunity was squandered – but no specific harm: food and energy price inflation has indeed historically been more volatile than core inflation. Food and energy price inflation has also, historically, been less persistent (more ‘mean-reverting’) than core inflation.

Chairman Bernanke’s second logical error is the mental leap from the correct statement that food and energy price inflation have historically been quite volatile (and more volatile than core inflation) to the conclusion that core inflation may be a better gauge of underlying inflation trends than overall inflation. Let’s also grant the Chairman the greater persistence, historically, of core inflation compared to food and energy price inflation.

This second logical error involves two ‘sub-errors’. The first reason Chairman Bernanke’s conclusion does not logically follow from his empirical observation is that he has to slip in the assumption that the future is going to be like the past he based his empirical characterisation on. In an earlier blog on this issue (The Folly of the Fed or: Why is the Fed so Hardcore? http://maverecon.blogspot.com/2007_06_01_archive.html ), I have pointed out that even the (recent) past (2002-2007) has not been like the past that Chairman Bernanke appears to base his empirical judgments on (probably something like 1987 – 2001) , and that the future is more likely to be like the recent past than the more distant past.

The key feature of the recent past has been the sustained, persistent and continuing increase in the relative price of food and energy to core goods and services, driven by globalisation and specifically by the entry into the global economy of China, India and other emerging giants as demanders of non-core goods and suppliers of core goods. There are reasons to believe that this pattern of a rising relative price of non-core goods to core goods will persist for a fair number of years, and that as a result, the expected inflation rate of food and energy will be systematically above the expected inflation rate of core goods and services.

The second sub-error is that even if the future were to be just like the past Bernanke appears to have in mind, and even if therefore food and energy inflation were to continue to be more volatile and less persistent than core inflation, it does not follow that core inflation “may be a better gauge than overall inflation of underlying inflation trends”. I interpret underlying inflation trends as the medium-term rate of headline inflation, where the medium term is the period over which current monetary policy decisions have most of their full effect on inflation- somewhere between one and three years probably in the US.

Given all this, would it be better to forecast future underlying inflation using just current and past headline inflation or just current and past core inflation? First, note that this is a silly question. It’s obvious that no rational human being would do either. You would in general use both current and past core inflation and current and past non-core inflation (or, equivalently, current and past core inflation and current and past headline inflation). It is wildly unlikely that there is no predictive content for future headline inflation in current and past food and energy inflation, even after we condition on current and past core inflation (see my earlier discussion of Granger causality tests in The Folly of the Fed or: Why is the Fed so Hardcore? http://maverecon.blogspot.com/2007_06_01_archive.html.). In fact, you would use any information, in addition to current and past core and headline inflation, that may have a sufficiently stable statistical relationship with future medium-term headline inflation. The craving for a single number, be it core inflation or headline inflation, that can serve as a sufficient statistic for all information relevant to the prediction of future inflation trend is very unhealthy and has, not surprisingly, led to a bad case of monetary indigestion.

As is clear from Chart 2, core inflation and headline inflation have, historically, been negatively correlated. This is comforting for those who believe that, in the long run, inflation is a monetary phenomenon (i.e. is made by central banks) rather than a relative price phenomenon, although it does not prove that belief to be correct This negative correlation means that, if it is possible to predict core inflation and non-core inflation (and if expected core inflation is not always expected to equal expected non-core inflation), one should use both core and non-core inflation to predict future headline inflation. The same logic also implies that, if future core and non-core inflation are sufficiently negatively correlated, you could do a better job predicting future headline inflation using just current and past headline inflation than you could using just core inflation, even if the volatility of non-core inflation is higher than the volatility of core inflation. Of course, as pointed out earlier, you would be crazy to use just one predictor if more are readily available.

Does the Fed not believe that, in the long run, inflation is a monetary phenomenon?

The basic confusion in the Fed appears to be the view that monetary policy determines underlying or trend core inflation and that they “they” (global oil markets, the weather, the Munchkins of OZ) determine the deviations of food and energy price inflation from core inflation. The shocks driving these deviations have a high variance, and the deviations are transitory. Food and energy price inflation converges to core inflation, with the core inflation being the dog and food and energy price inflation the tail. Non-core inflation is beyond the ability of the Fed to influence and is effectively treated as exogenous to the monetary policy decision.

This is the only theory that allows me to make sense of the utterances coming out of DC, other than the indefensible theory that the Fed believes that the best predictor of tomorrow’s relative price of core and non-core goods is always today’s relative price. If this Canine Theory of Inflation is what the Fed believes, it is bad monetary economics. If one has to have dogs and tails in the monetary transmission mechanism story, the better story is the following. Monetary policy (the Fed in the USA) determines the underlying inflationary trend for headline inflation. This is the dog. Both core inflation and non-core inflation are ‘tails’ in the following sense.

“They” (globalisation, Opec, the weather, the Munchkins of OZ) determine the equilibrium changes in the relative price of non-core and core goods. The actual, real-time behaviour of the non-core and core components of the price index does not match what their behaviour would be under full nominal price flexibility for both core and non-core goods, that is, with instantaneous full adjustment to the equilibrium relative price of core and non-core goods. Instead, the prices of core goods and services are subject to nominal rigidities and tend to adjust only gradually in response to differences between their actual and equilibrium values. Non-core prices are fully flexible and therefore can and do jump around a lot more than core prices. Since core goods prices (and indeed core goods inflation rates) are sticky, non-core goods and prices (and indeed non-core goods inflation rates) will often overshoot their equilibrium values in the short run. In the absence of further relative price changes between core and non-core goods and other shocks, both core and non-core inflation rates will converge to the underlying trend headline inflation rate determined by the central bank.

While better, the second story is also not fully satisfactory. In a well-articulated model of a monetary economy, what “they” do to the equilibrium relative price of core and non-core goods and what the Fed does to determine the underlying inflationary trend for the headline price index are jointly endogenously determined. But if you want a simple story, the second one is much less dangerous than the first.

It is possible that there will be no further increases in the relative price of non-core to core goods in the next few years. In that case, predicting headline inflation is predicting core inflation (or predicting food and energy inflation). In that case, and in that case only, no harm is done by the Fed’s defective analytical and predictive framework.

It is possible, but not likely. Headline inflation has been well above any reasonable notion of price stability (say, a point target of an annual rate of PCE inflation of 1.5%, corresponding to an annual CPI inflation rate of around 2.0%), ever since the third quarter of 2002 (see Chart 1) . So for the past 5 years, the Fed has either systematically under-predicted the underlying inflationary pressures or failed to raise interest rates by enough and fast enough to keep headline inflation near the target. From the statement of Chairman Bernanke, it looks as though there is considerable persistence in this prediction error/policy implementation error.

Chart 1

Source: Bureau of Economic Analysis, Quarterly data, SA.

Chart 2

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Plugging the Hole in the UK and Eurozone Inflation Targets

The price indices used to define the UK inflation target (2 percent per annum) and the inflation rate deemed consistent with price stability in the Eurozone (below but close to 2 percent per annum) are a disgrace. They make sense only if the inhabitants of the UK and the Eurozone are homeless and sleep under bridges. The reason is that there is no component in the Harmonised Index of Consumer Prices (HICP) used to define the operational inflation targets in the UK and in Euroland, that tries to capture housing cost inflation.

Let me start by saying that I hold the view that the price index used to define the operational inflation target should be the best possible practical approximation to the cost-of-living-index of Mr & Ms Average and the rest of their nuclear family. I know that in Euroland, the statistical experts that control Eurostat deny that the HICP is or should try to be a cost-of-living-index. They are wrong. If the price index defining the central bank’s inflation target does not try to approximate a representative cost-of- living-index, it is useless and should be discarded.

The housing cost measure that should enter the price index is clear in principle: it is the actual rental cost (of people living in rented accommodation) or the imputed ‘shadow rental cost’ for owner-occupiers – what economists call the ‘user cost’ of housing capital. This market or shadow price of the flow of housing services is quite distinct from the price of a house. If markets function properly, the price of the house is the present discounted value of the future rental cost of the house, using the appropriate risk-adjusted discount rates. Measuring housing cost inflation is difficult when the housing rental market is heavily regulated, distorted, price-controlled, publicly owned and/or unrepresentative of the housing cost experience of a large part or even most of the population. Such is certainly the case in the UK.

The response of the Eurostat statisticians to the problem of getting a reasonable measurable proxy for the true shadow rentals of the housing stock – one that has to be comparable across the 13 (soon to be 15) countries of the Eurozone – has been to exclude housing costs from the Eurozone HICP index altogether. This amounts to the assumption that the inflation rate of housing costs is the same as the inflation rate of the rest of the price index. Whatever the merits of this assumption for the Eurozone (in Spain and Ireland it grossly underestimates true housing cost inflation; in Germany it may well overstate it), the assumption that housing cost inflation is the same as the inflation for the rest of the UK consumer price index (CPI) is a howler. With housing costs probably around a quarter of the median household’s budget, and with housing cost inflation outstripping CPI inflation year after year, using the CPI to define the inflation target is becoming as much of an embarrassment in the UK for the MPC – and, a fortiori for the Chancellor, who is responsible for this state of affairs – as the Fed’s obsession with core inflation is becoming a source of embarrassment for the FOMC.

Any reasonable estimate of the UK housing costs have been rising much faster than the CPI for many years in most of the UK. As the Chart below shows, the UK Retail Price Indices, both the all-inclusive RPI and the Bank of England’s old inflation target index, RPIX (RPI exclusive of mortgage interest payments but inclusive of some other, admittedly unsatisfactory, proxies for the cost of housing services) have been showing rates of inflation well above that for the CPI since early 2003, when the UK housing market went into overdrive. There are technical reasons other than the omission of housing costs from the CPI why the RPI and RPIX tend to show higher inflation than the CPI: even with constant nominal interest rates and housing inflation at the same rate as the inflation rate in the rest of the economy, RPI and RPIX inflation tend to exceed CPI inflation by between 0.50% and 0.75% per annum (for the inflation rates observed since the early 1990s). But the gap is big enough to matter economically and politically.

The user cost of housing during a year (what you would have to pay in a competitive market to rent the house for that year) can be approximated as the product of the price of the house at the beginning of the year and the sum of four terms. These are: (1) the risk-free rate of interest for that year, (2) the risk premium on housing, (3) the depreciation rate of the housing stock and (4) minus the percentage capital gains on the house over the year (taxes paid by tenants, like the UK’s Council Tax, must also be included).

Of these four key inputs in the calculation of the consumer’s cost of housing services, the second, the risk premium on housing, is unobservable, but possible proxies can be thought of, including the equity risk premium for property companies and similar observable risk premia. Alternatively this user cost estimate could be combined with sample evidence on actual rents paid in that part of the UK residential rental market that is reasonably competitive.

It is not beyond the wit of the National Statistical Office to come up with a monthly estimate of the consumer’s cost of housing services that could be included in the UK’s CPI right now. It will be imperfect, but it is bound to be better than the blatantly systematically incorrect assumption that is currently made – that housing cost inflation is the same as the inflation rate of the rest of the CPI.

Euroland may have to move at the pace of its slowest member state when it comes to including a housing cost component it its HICP index. The UK is not constrained by that. The case for moving swiftly is strong. Inflation targeting by the Bank of England will be discredited if, when the Bank achieves its 2 percent CPI mandate, everyone who can walk and chew gum knows that the true rate of inflation, which includes housing costs, is significantly above 2 percent. So what are we waiting for? It is better to be approximately right than precisely wrong.

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Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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