Those of you with time on your hands and a interest in spending some it it in a basement being beaten with a rubber hose, may want to take a look at my recent Centre for Economic Policy Research Policy Insight No. 24, “Can Central Banks Go Broke?”

In that paper, I ask whether it matters if a central bank suffers a large capital loss. Can the central bank become insolvent? How and by whom or by what institution should the central bank be recapitalised, if its capital were deemed insufficient? These are relevant questions not just in Zimbabwe and Tajikistan today, but whereever central banks have taken on or may be asked to take on large exposures to private credit risk. This includes the USA, the Euro Area, the UK, Iceland and many other advanced industrial countries. (more…)

What is inflation?

Inflation is rising just about everywhere. Why is this and what can be done about it?

To get some basic concepts clear: inflation is a sustained rise in the general price level. Both the words ’sustained’ and ‘general price level’ are imprecise and in need of operationalisation. By general price level I mean a broad, representative index of consumer prices. That excludes the (headline) CPI in the UK because, like the other EU harmonised price indices, it excludes housing costs (that is, the rental cost of housing services or the imputed rental paid by owner occupiers). This makes the CPI/HICP indices unrepresentative, unless either the relative price of housing services and the goods and services included in the CPI/HICP remains constant or UK/EU citizens live in cardboard boxes provided free of charge by the Salvation Army. It may come to that, but not yet. The UK’s RPI and RPIX indices would be more representative.

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The UK Chancellor of the Exchequer, Alistair Darling, is fighting the good fight on policy towards the EU’s agricultural sector. Effectively, he has called for the abolition of the Common Agricultural Policy, the EU’s Welfare State for Farmers - a costly, distortionary, inefficient and inequitable arrangement overdue for the scrap heap. (more…)

Slovakia have done it! They have got the nod both from the European Commission and, albeit reluctantly, from the European Central Bank. Following the confirmation of these recommendations by the European Council, Slovakia will join the Euro Area on January 1, 2009. The only question mark that hung over this application for Euro Area membership was Slovakia’s inflation performance. The European Commission was unambiguous on the issue in its Convergence Report 2008: “Slovakia fulfils the criterion on price stability.”

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When I hear or read the words ‘off-balance-sheet financing’ or ’special purpose vehicle’, warning lights begin to flash and I grab for my obfuscatometer. Off-balance-sheet financing is any form of funding that avoids placing the owners’ equity, liabilities or assets on the balance sheet of a firm or other legal entity. The most common way to achieve this is by placing those items on some other entity’s balance sheet. A standard approach is to create a special purpose vehicle (SPV) and place assets and liabilities on its balance sheet. An SPV is a firm or other legal entity established to perform some narrowly-defined or temporary purpose.

There are circumstances (possibly as many as one percent of the reported occurrences of SPVs), where such entities are created to achieve true efficiency gains. For instance, creating a separate legal entity for certain activities may better align incentives for risk-sharing or may avoid conflict of interest. The overwhelming majority of SPVs are, however, created for nefarious and/or dishonest purposes: evading or avoiding regulation (and associated financial burdens and constraints or reporting obligations); tax avoidance or tax evasion; accounting shenanigans, including the circumvention of ceilings on the budget deficit or debt of public entities; and hiding assets or liabilities from scrutiny by interested parties. These often clever schemes are always economically equivalent to a much more straightforward on-balance-sheet arrangement. (more…)

The Institute of International Finance,  an organisation representing many of the world’s largest banks and other financial companies, has issued a pretty frank mea culpa for the litany of errors of omission and commission perpetrated by its members during the financial boom that turned to bust in August 2007.  The Interim Report of the IIF Committee om Market Best Practice states a large number of home truths and makes a host of useful suggestions about risk management, liquidity managements, compensation of senior bankers and superstars, over-reliance on formal quantitative models etc.

The tone of the report is one of “We know we screwed up, but now we’ve learnt our lesson (really we have!!) and we’ll never do it again; so there is no need to regulate us more severely and intrusively”. (more…)

Mr Greenspan’s apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince.

1. The Greenspan Fed (August 1987 - January 2006) did indeed contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
2. The Greenspan-Bernanke put is real. It is an example of an inappropriate monetary policy response to a stock market decline.
3. The Greenspan Fed focused erroneously on core inflation, rather than using all available brain cells to predict underlying headline inflation in the medium term.
4. The Greenspan Fed failed to appreciate the downside of the rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for its undoubted virtues.
5. The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
6. The Greenspan Fed, by enabling the rescue of Long Term Capital Management in 1998, acted as a moral hazard incubator.
7. The failure of the Greenspan Fed to press, before or after LTCM, for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail, demonstrates either bad judgement or regulatory capture.
8. During his years as Chairman of the Federal Reserve Board, Mr. Greenspan’s statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator. Mr Greenspan’s theories have been comprehensively refuted by the financial crises of 1997/98 and 2007/08. (more…)

This blog is a comment on Martin Wolf’s Column in the Financial Times of Friday April 4, 2008, “Four falsehoods on immigration”.

Martin and I have crossed swords before on the issue of immigration. Our disagreement is fundamental and based on different ethical premises. Martin believes that existing residents of a country have a right to control who enters their country. The House of Lords select Committee shares this view, as is clear from their Report, The Economic Impact of Immigration, which asserts that the criterion to be used to assess the costs and benefits of immigration for the UK is the impact on the existing resident population.

I reject that view. The wellbeing of the existing resident population is no more, and no less, relevant than the wellbeing of any potential immigrant to the UK, wherever in the world he or she may be. I recognise private property rights. My home is my castle and I can deny entry into it to anybody at any time. I don’t recognise national property rights. A country is not like a private home. A country is an open club.

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US Treasury Secretary Henry Paulson proposes that the Federal Reserve be given powers it does not have today, to demand information from/inspect the books of /impose constraints on the behaviour of - the primary dealer-brokers (that is, investment banks), for as long as the Fed is providing these investment banks with money through open market operations (via the Term Securities Lending Facility (TSLF) ) or at the Fed discount window (through the Primary Dealer Credit Facility(PDCF)). Once the investment banks stop suckling at the Federal Reserve nipple, however, the new supervisory/regulatory role of the Fed vis-a-vis the investment banks would shrivel and the ancien regime would re-emerge more or less intact.

This proposal is a recipe for increasing financial instability. The times when the Fed comes to the rescue of stricken investment banks is when the bad investments made during the most recent period of financial excess come home to roost. These are the times that the fundamental worsening in the financial prospects of this sector is amplified by liquidity crises and crunches. Systemically important financial markets (like the interbank market, the ABCP markets, other ABS markets and wholesale capital markets across the board) dry up as lack of trust and confidence, fear and panic replace euphoria, hubris, over-confidence and master-of-the-universe-syndrome. Under those circumstances there is never any objection from the afflicted private financial enterprises to the Fed asking awkward questions and sticking its nose in the books, as long as the central bank is willing to take assets off their books at prices well above what could be realised in an impaired, inefficient, free market. Beggars can’t be choosers.

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My friend Professor Avinash D. Persaud recently gave a speech to the Committee of European Securities Regulators (CESR) on why bank risk models failed and are bound to fail. It is today’s guest blog. Avinash is a trustee of the Global Association of Risk Professionals, Chairman of Intelligence Capital Limited and Emeritus Professor of Gresham College.

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Sir Alan Greenspan, and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical. Neither is complex, but many regulators and central bankers chose to ignore them both.

The technical explanation is that market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them. This was not a bad approximation in 1952, when the intellectual underpinnings of these models were being developed at the Rand Corporation by Harry Markovitz and George Dantzig. This was a time of capital controls between countries, the segmentation of domestic financial markets and to get the historical frame right, it was the time of the Morris Minor with its top speed of 59mph. (more…)