Thursday April 29, 2010
IPE Leiden

Agustin Mackinlay

Session 5. Central Banks
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[1] A word on the Greek crisis: Flight-to-quality!

[2] On some issues from Session 4

[3] Central Banks

[4] The Political Economy of China’s economic development model & the international reserve currency (Introduction). We need to read the following article (it is a bit difficult, but we will discuss it in detail, most probably during Session 6) — Michael P. Dooley, David Folkerts-Landau & Peter Garber: “An Essay on the Revived Bretton Woods System”, NBER Working Paper 9971, September 2003.
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The Greek Crisis: Flight-to-Quality!

Change in sovereign 10-year credit spreads: April 22 (Germany 3.08%; Greece 7.83%; spread = 4.75%). April 28 (Germany 2.93%; Greece 10.36%; spread = 7.43%). Note that resources are taken out of Greece (where interest rates go up), and into Germany (where interest rates go down). The very definition of a flight-to-quality episode! [Note: we should also take the entrepreneurs’credit market into account]

From Bloomberg News:

Standard &Poor’s lowered Greece’s credit rating to BB+ from BBB+ and warned that bondholders could recover as little as 30 percent of their initial investment if the country restructures its debt. [SOME INSTITUTIONAL INVESTORS ARE NOT ALLOWED TO HOLD BBB+ RATED DEBT, SO THEY ARE FORCED TO QUIT LENDING TO GREECE!] The downgraded marked the first time a euro member has lost investment grade rating since the currency’s 1999 debut. S&P also reduced Portugal by two steps to A- from A+. German Chancellor Angela Merkel said yesterday she won’t release funds to help Greece shore up its finances until the nation has a “sustainable” plan to reduce its budget deficit. Germany’s Economy Minister Rainer Bruederle said Greece needs to present a plan to overcome its debt crisis as soon as possible.

The yield on the Greek two-year note rose 5.05% to 18.99% yesterday, more than 20 times the comparable German bond and 6 percentage points more than similar-maturity notes from Pakistan. Portugal’s 10-year bond yield jumped 0.41% to 5.724 percent, and Irish 10-year yields surged 0.19% to 5.10 percent. Investors are trying to avoid being caught by the “next Greece,” said Olaf Penninga, who helps manage 140 billion euros ($187 billion) at Robeco Group, an 80-year-old Rotterdam-based asset manager. Portugal plans to raise as much as 25 billion euros this year, equivalent to 15 percent of GDP. That compares with 21 billion euros last year, according to the national debt agency. “As spreads get higher the problems are getting bigger: it’s a self-fulfilling prophecy,” [THIS IS INTERESTING! WHAT DOES HE MEAN BY “SELF-FULFILLING PROPHECY"?] Penninga said in a telephone interview. “It will get more difficult now for Portugal to tap markets.” Robeco reduced exposure to Portuguese bonds last year and sold the last ones in March. The spread on the debt of Italy, the euro region’s third-largest economy, rose 0.30% to 217 points.

[NOW TO SOME “RISK-FREE” ISSUERS] In Japan, 10-year yields to the lowest level in four months, falling 0.025% points to 1.28 percent. “It was absolute carnage,” boosting demand for safer securities such as U.S. Treasuries, Adam Carr, senior economist in Sydney at ICAP Australia Ltd., wrote to clients. The yield on the 10-year slid to 3.67% yesterday, the lowest since March 23 and the biggest drop since Dec. 17. Meanwhile, German bond yield collapsed to 2.93%. “It’s the fear [FEAR!] that Greece or Portugal may affect other areas of Europe and derail this economic recovery,” said Burt White, chief investment officer at LPL Financial in Boston, which oversees $379 billion. “There’s now a perception that we might see Greece or Portugal failing. “People are panicking about the contagion effect,” [PANIC!] said Sydney-based Simon Bonouvrie, who helps manage $1.7 billion at Platypus Asset Management. “It’s an overreaction but the risk aversion will remain until these problems are resolved.”


On some issues from Session 4: The Political Economy of Greed & Fear

. During a flight-to-quality episode, interest rates are mostly determined by the seemingly irrational behavior (fear!) of thousands of individuals who act in panic to protect their capital.

. In such times, interest rates for risky borrowers (entrepreneurs and risky sovereign issuers) increase, while interest rates for “risk-free” issuers decrease. Thus, risk-free sovereign borrowers find themselves in a better position to provide bailout packages to their financial systems, and to fund economic stimulus measures.

. In political economy terms, flight-to-quality episodes of significant magnitude (such as the one triggered by the Lehman Brothers bankruptcy) will affect the interplay between the state and the market, as well as international relations.

. Four elements of the Political Economy of Greed & Fear: [1] Moral hazard; [2]
Womenomics!; [3] the Minsky paradox; [4] International reserve currencies.
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[1] Moral Hazard. Within a country, moral hazard can be loosely defined as the sum of contingent liabilities assumed by the state as a result of the various explicit and implicit safeguards provided to the financial system -- bailout packages, deposit insurance extension, credit guarantees, etc. [See Martin Wolf: “Under the gold standard, the scale of bailouts was constrained. In a fiat system, there is no such limit, until the value of money collapses”, Financial Times, April 28, 2010]. At the international level, moral hazard refers to the incentives of governments to increase public spending, in the knowledge that an IMF-led bailout package will be forthcoming in case of crisis.

The 1994-1995 Mexican crisis provides much material in terms of the political economy of moral hazard. At the domestic level, actions taken by the authorities in 1994 –bailing out several banks– may have induced other banks to take on more risks. At the international level, the 1995 IMF-led bailout package to the Mexican government –brokered by the Clinton administration– may have induced other countries to increase public spending. Eventually, as a result of the 1997-1998 financial crisis, many Asian nations were granted IMF bailout packages. Note that, with the arrival of the new administration in 2001, the United States explicitly withdrew any explicit or implicit commitment to provide bail-out packages to individual countries. US Secretary of the Treasury Paul O’Neill branded Argentina as a leading showcase: no bailout, less moral hazard!
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Documents on moral hazard

Document 1. Ben Bernanke speech March 10, 2009 [The text captures well the incessant tug-of-war inside the minds of policy-makers!]

Too Big to Fail. In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy. However, the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. And it creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support. Moreover, government rescues of too-big-to-fail firms can be costly to taxpayers, as we have seen recently. Indeed, in the present crisis, the too-big-to-fail issue has emerged as an enormous problem. In the midst of this crisis, given the highly fragile state of financial markets and the global economy, government assistance to avoid the failures of major financial institutions has been necessary to avoid a further serious destabilization of the financial system, and our commitment to avoiding such a failure remains firm. Looking to the future, however, it is imperative that policymakers address this issue by better supervising systemically critical firms to prevent excessive risk-taking and by strengthening the resilience of the financial system to minimize the consequences when a large firm must be unwound.
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Document 2. Alan Blinder, January 25 2009 [Against the “moral hazard gods”!]

LETTING LEHMAN GO: The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled —with other financial institutions— to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman.
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Document 3. Joachim Fels, Morgan Stanley, April 16 2010 [Greece & Moral hazard at the international level]

The lesson for other euro area members from the Greek bail-out package is that no matter how badly you violate the SGP guidelines, financial help will be forthcoming, if push comes to shove. This introduces a serious moral hazard problem into the European equation. Fiscal slippage in other countries has now become more rather than less likely. Second, the ECB's climb-down on its collateral rules regarding lower-rated bonds, which ensures that Greek government bonds will still be eligible as collateral in ECB tenders beyond 2010, adds to this moral hazard problem and confirms that the ECB is not immune to political considerations and pressures. Don't get us wrong: It is quite obvious that if Greece had not received a financial backstop package and if the ECB had stuck to its previous pronouncements on the collateral rules, the consequences not only for Greece but the whole euro area financial system and the economy could have been dire. However, the unintended consequence of such action is that it sows the seeds for potentially even bigger problems further down the road.
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Document 4. The New York Times & the Wall Street Journal on Greece & moral hazard

The Wall Street Journal's editorial page takes the view that the imminent aid package to Greece will only exacerbate moral hazard (see "Europe's Bear Stearns"). Note the sharp contrast with the New York Times, who is calling for "a much bigger bailout package" ("Greece and Who’s Next?"). Realism vs. liberalism, anyone?
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[2] Womenomics!

The point that I want to make here, very briefly, is that interest rates in the credit markets result from millions of individual decisions … Institutional factors are important (Session 3), and central banks too. But more and more attention is devoted to the role played by emotions, and how best to manage them.

Some documents

Document 1. J. M. Coates & J. Herbert: “Endogenous steroids and financial risk taking on a London trading floor”, Proceedings of the National Academy of Sciences, April 2008 [Judge Business School, University of Cambridge, Cambridge CB2 1AG, United Kingdom ; Cambridge Center for Brain Repair, University of Cambridge, Cambridge CB2 0PY, United Kingdom]. Edited by Bruce S. McEwen, The Rockefeller University, New York, NY, and approved November 6, 2007 (received for review May 1, 2007)

Abstract. Little is known about the role of the endocrine system in financial risk taking. Here, we report the findings of a study in which we sampled, under real working conditions, endogenous steroids from a group of male traders in the City of London. We found that a trader's morning testosterone level predicts his day's profitability. We also found that a trader's cortisol rises with both the variance of his trading results and the volatility of the market. Our results suggest that higher testosterone may contribute to economic return, whereas cortisol is increased by risk. Our results point to a further possibility: testosterone and cortisol are known to have cognitive and behavioral effects, so if the acutely elevated steroids we observed were to persist or increase as volatility rises, they may shift risk preferences and even affect a trader's ability to engage in rational choice.
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Document 2. Roger Boyes: "Age of Testosterone comes to end in Iceland", TimesOnline (February 7, 2009)

Iceland, ravaged throughout history by volcanic eruptions and natural catastrophes, is struggling with a man-made disaster so overwhelming that the women are taking over. It is, they say here, the end of the Age of Testosterone. Next week a newly minted left-leaning Government led by Johanna Sigurdardottir will start to tackle the tough agenda of cleaning out the old-school-chum networks that have led Iceland to the verge of bankruptcy. Half of her Cabinet will be women; female advisers carrying briefcases move in and out of the Prime Minister's whitewashed office, a former jailhouse in the middle of Reykjavik. Two women, Birna Einarsdottir and Elin Sigfusdottir, now run the struggling and disgraced New Landsbanki and New Glitnir banks. We have to create a new sense of solidarity,” says the Social Democrat Prime Minister. The departing Government — retreating would be more precise — put business first, people second, say the premier's counsellors. Now is the time for a shift in values. Listening to Ms Sigurdardottir talk in her dry, schoolmistress manner, it becomes clear that the fall of the Icelandic Government was not just the first political casualty of the global downturn, but also a signal that men in suits have led the world astray. “We are going to base our economic policies on prudence and responsibility, but we also stress social values, women's rights, equality and justice,” she says. “You can see what is happening,” says Katrin Olafsdottir, Associate Professor of Economics and a member of the board of New Glitnir, which is trying to devise a new mission for the crippled bank. “The men went out there and took these incredibly irrational risks — and getting loads of money for doing it, feeling really good about it - and then the women have to come in to clean it up.”
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Document 3. Renée Adams & Daniel Ferreira: “Women in the Boardroom and Their Impact on Governance and Performance”, October 2008

Abstract. We show that female directors have a significant impact on board inputs and firm outcomes. In a sample of US firms, we find that female directors have better attendance records than male directors, male directors have fewer attendance problems the more gender-diverse the board is, and women are more likely to join monitoring committees. These results suggest that gender-diverse boards allocate more effort to monitoring.
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Some books & articles on emotions, the economy, credit markets:

. Akerlof, George A. & Schiller, Robert A. Animal Spirits. How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism (Princeton University Press, 2009) [see]

. Brassey, Alex. Greed (London: Macmillan, 2009) [see].

. Gasparino, Charles. The Sellout. How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System (New York: HarperBusiness, 2009) [see]. From a Financial Times review: “Gasparino narrates convincingly how banks such as Bear [Stearns] slipped into risking ever more capital, often without the full understanding of their leaders, who were engaged in a contest to see who could catch up with Goldman Sachs”. The same, by the way, could be said about Swiss bank UBS.

. Tett, Gillian: “The emotional markets hypothesis and Greek bonds”, Financial Times, April 10/11 2010.

. Turner Review. A regulatory response to the global banking crisis (London: Financial Services Authority, 2009). See p. 41: “Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings”.
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Some websites about economics & credit markets:

. PIMCO. Perhaps the world’s top credit markets analysts

. Morgan Stanley’s Global Economic Forum.
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