The Euro Crisis

An interesting piece today in Spiegel: The Euro Crisis.
Take a look at this (a few pics reproduced below).

Duffie in Defense of Speculation

Darrell Duffie explains here why speculation is not a four-letter word (In case you do not subscribe to the WSJ, I reproduce the article below).

It's a nice and easy read. But I couldn't help notice that he does not exactly define the term for us (nor, for that matter, do those who wish to pass laws to prohibit the practice).

He seems to identify "speculators" as relatively risk-tolerant agents. These type of agents provide a social good by their willingness to absorb risk, giving the rest of peace of mind.

Of course, their willingness to absorb risk is not necessarily the same thing as their ability to absorb risk. If things turn out very poorly, the rest of us will be asked to absorb the risk. So maybe these "speculators" aren't quite as risk tolerant as they are made out to be (since they have no risk to bear when things turn out badly).

Hmmm...how to define these terms? Perhaps we need some sort of Devil's Dictionary (by Ambrose Bierce, in case you haven't read this--it is brilliant). OK, I propose to hold a contest. Please submit your preferred (cynical) definition of either "speculator" or "speculation." Here's mine:

Speculation (n): The risk-taking behavior of other people.

================================

By DARRELL DUFFIE
George Soros, Washington Democratic Sen. Maria Cantwell and others are proposing to curb speculative trading and even outlaw it in credit default swap (CDS) markets. Their proposals appear to be based on a misconception of speculation and could harm financial markets.
Speculators earn a profit by absorbing risk that others don't want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.
Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment's value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country's default.
Is this sort of speculation wrong? I have not heard why.
Those who call for stamping out speculation may be confused between speculation and market manipulation. Manipulation occurs when investors "attack'' a financial market in order to profit by changing the value of an investment. Profitable speculation occurs when investors accurately forecast an investment's fundamental strength or weakness.
An example of manipulation is an attack on a currency with a fixed exchange rate in an attempt to cause a devaluation of that currency. Mr. Soros allegedly attacked the British pound in 1992 and the Malaysian ringgit in 1997. An attack on the equity or CDS of a bank could create fears of insolvency, leading to a bank run and allowing the manipulator to profit from his attack.
In the week of Lehman Brothers' bankruptcy in September 2008, John Mack, then CEO of Morgan Stanley, suggested that the difficulties facing his firm stemmed from such an attack. But firms complaining of unfounded short-selling often had real problems beforehand.
A market manipulator can also attempt to profit by "cornering" a market. This is done by holding such a large fraction of the supply of an asset that anyone who wants to buy that asset is at the mercy of the corner holder when negotiating a price.
The market for silver was temporarily cornered in 1979-80, when Nelson Bunker Hunt and his brother William Herbert Hunt held silver derivatives representing approximately half of annual global silver production. In the end, the Hunt brothers were unable to maintain a corner. As they sold, silver prices fell, causing them calamitous losses.
Market manipulation for profit is not easily done. If the fundamentals of supply and demand suggest that the value of something is $100, then a manipulator must buy at prices above $100 in order to drive the price up or to accumulate a monopolistic position. He then owns an asset that on paper could be worth more than what he paid for it. However, he must sell his asset in order to cash in on his profit. This spurs the price of that asset to fall, as the Hunt brothers learned.
Simply driving up the price, as speculators are alleged to have done in the oil market in 2008, is not enough. To make a profit, a manipulator needs to obtain monopolistic control of the supply. Given the size of the oil market, that seems implausible, absent a major and sustained conspiracy.
In the United States, trade with an intent to manipulate financial markets is generally illegal. Regulators should keep anti-manipulation laws up to date and aggressively monitor potential violators.
Speculation is not necessarily harmless. If a large speculator does not have enough capital to cover potential losses, he could destabilize financial markets if his position collapses. The Over-the-Counter Derivatives Markets Act, which could come up for a vote in the Senate soon, will hopefully reduce such risks.
It would be better for our economy to enforce anti-manipulation laws, and require that speculators have enough capital to cover their risks, than to attempt to squash speculation.
Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.

Outing the Fed

It is said that we get the government we deserve. Well, if this is true, then judging by the vitriol spilling out of the mouths of some of our elected representatives, we are all morons.

Here's the latest, from the Nation: Outing the Fed. Some selected tidbits with commentary follow.

Rep. Alan Grayson, the first-term Florida Democrat who partnered with Paul to pass the House version, has a distinctive way of explaining things with brutal clarity. "Fed Chairman Ben Bernanke doesn’t want an audit because Ben Bernanke doesn’t want to be audited," Grayson said. "Treasury Secretary Tim Geithner, the former head of the New York Fed, doesn’t want an audit because Tim eithner doesn’t want to be audited."

This sanctimonious twit should be tarred and feathered for his hypocrisy. (Wouldn't we all love to see the skeletons in his closet). In any case, he continues to propagate the myth that the Fed is never audited. I have addressed this issue here.

Forget all the official blabber about "Fed independence." The central bank has never been independent from the most powerful bankers it is supposed to regulate. The everyday relationship is incestuous. What the Fed and its main constituency of Wall Street power houses really fear is that people will get a better look at their corrupt private dealings. During the financial crisis, the central bank handed out something like $2 trillion in emergency loans and other goodies. All efforts by Grayson and others to find out who exactly got this money were rebuffed by the Fed governors. Bloomberg sued for disclosure and won in Federal court. The Fed is appealing the ruling.

Please explain this "everyday incentuous relationship" that the Fed evidently has with the big banks it is "supposed to regulate." As I explained here, the Fed has primary regulatory authority over only 15% of the nation's banks (whether measured by number of banks, or by assets). What on earth are they talking about here?

Yes, during the crisis the Fed did "hand out" something like 2 trillion in emergency loans (and other "goodies"? like what?). What is conveniently ignored here is that most of this emergency lending has been repaid with penalty interest rates. Perhaps they have failed to notice that the Fed remitted an extra $25 billion or so in 2009 to the Treasury; see here. Yes, yes...I demand to know who the Fed lent all this money to that was ultimately repaid with a very high return! Who were the recipients of this bailout!? (Blah, blah, blah...in the meantime, with Congress handing out bona fide bailout money to its favored special interests...)

Central Banks as Sources of Financial Instability

George Selgin has written an interesting piece here, explaining why the institution of central banking is inherently destabilizing (relative to an institution of free-banking). I have a lot of sympathy for what he has to say here, although I do have some reservations. (Thanks to Prof J for sending this to me).

Selgin begins by describing how a free-banking systems works. Competitive banks issue paper liabilities made redeemable on demand for specie (historically, these paper notes also constituted senior claims against the bank's assets in the event of bankruptcy; i.e., they were backed beyond the available specie held in reserve). Banks would create these notes whenever they wanted to make a money loan. The money loan would be extended against sufficient collateral (hence, the paper issued by the bank was backed, at least in part, by the collateral backing its loan portfolio).

Question: what prevents individual banks from "over-issuing" the paper money that they can evidently create "out of thin air?" Answer: the principle of adverse clearing. What is this? As banknotes circulate, a portion are redeemed for specie (either directly by people, as when you or I visit an ATM, or by other banks who have received deposits consisting of other banks' notes. This continual flow of redemptions is what keeps the supply of credit in check: banks that issue too many notes will have trouble honoring their redemption obligations, leading to bankruptcy.

I have some sympathy for this argument, but I wonder whether it is entirely correct. One might note that Microsoft shares are not made redeemable on demand for anything (although they are backed by capital). What prevents Microsoft, or any other company for that matter, from "overissuing" its debt obligations? There is no principle of adverse clearing at work here.

A central bank is defined by Selgin as an agency that has monopoly control over the supply of small denomination paper notes. As Selgin rightly notes, the monopoly was usually conferred by resource-hungry sovereigns. Private banks would deposit their specie with the central bank, and issue liabilities (checkable deposits) redeemable in central bank money (rather than specie). Or something like this...practices likely varied across space and time. In any case, the point is that the central bank is no longer subject to the force of adverse clearing.

If I understand his argument correctly, all I think he is saying is that the central bank is now in control of the object of redemption (specie in free-banking). There is very little economic discipline on how a central bank manages the base money supply. It can overissue, leading all banks who make their liabilities redeemable in central bank money, to overissue as well. A credit bust inevitably follows the resulting boom in credit.

Well, I suppose. On the other hand, an independent central bank might choose to keep the supply of base money in check. What is the difference now between bank liabilities made redeemable in specie or central bank paper? In fact, the latter might be superior in that it frees the specie from its role as idle reserves...the gold and silver can now be used for other purposes.

Of course, central banks have behaved badly in the past. But this has almost always been because of pressure from the fiscal authority. Even a free-banking system is not free from the grabbing (and destabilizing) hand of the state.

EU Farm Subsidies...to the Queen?

Whatever your view on subsidies to farmers, you have to admire their ability to milk the public teat. Farmers like...well, like Queen Elizabeth, for example.

See: European Subsidies Stray from the Farm (thanks to Martin Gervais for the link).

Here is an excerpt that I found especially interesting:

Overall the biggest slice of the farm subsidy cake still goes in direct payments for farmland. But even in this category there is controversy.

Providing the land is cared for and meets environmental standards, it does not need to be farmed to qualify for a subsidy. Mere ownership is enough, and therefore the wealthier the landowner, the larger the handout is likely to be.

The queen of England qualified for £473,500, or $778,812, in total farm aid in 2008 for Sandringham Farms in England, a 20,000-acre royal retreat that has been a private home to four generations of British monarchs since 1862. A pet project of Prince Charles to preserve the Transylvanian countryside also qualified for a nominal sum. Prince Albert II of Monaco collected €507,972 in 2008 for his wheat farms in France.

The duke of Westminster — the third richest person in Britain with a fortune estimated at £6.5 billion — collected £486,534 for his farm. Top Farms, the duke’s Polish distributor for his bull breeding company, Cogent, collected more than €8 million in subsidies from 2006 to 2007 for its dairy farms in Poland.

The Volcker Rule

A number of my colleagues and myself (at the FRB St Louis) attended a meeting yesterday with Paul Volcker to hear him opine on the so-called Volcker rule. (He spoke later that evening at Washington University; see here). I haven't followed the debate on financial sector reform very closely, so I learned a few things.

The central "problem" is the too-big-to-fail issue. How do we deal with it? Enter the Volcker rule.

If I understand correctly, the Volcker rule consists of two parts: [1] A rule determining which institutions are in and out of the social safety net; and [2] A rule determining how institutions out of the safety net, yet important to the financial system, are to be treated in the event they become distressed.

In a nutshell, rule [1] says you are in if you act like a traditional deposit-taking bank. If you want to engage in proprietory trading, then fine, but you will not be included in the safety net (e.g., access to the discount window). Rule [2] consists of some sort of "resolution authority" with the mandate to take over any troubled financial firm that threatens the system, and liquidate its assets in a timely manner. These firms will be allowed to fail.

I do not think that Volcker pretends that this is the solution to the TBTF problem or that this rule, in itself, will lead to perpetual stability. He seems to think, however, that it is an important first step. Well, naturally we had a few questions.

I decided to bring up a few points raised by Steve Williamson here on why TBTF does not seem to a problem in Canada. He replied that Canadian banks were more prudent in their lending. I tried Steve's line that this was likely the product of better regulation; there is no Volcker rule, as far as I know, in Canada. His reply, at least a part of it, was that Canadian banks did not engage in a lot of proprietory trading anyway.

Well, what could I say? I let it lie there. There were, after all, many other things to talk about. I thought it interesting that he brought up the issue possible systemic risk among those firms outside the safety net. Could the resolution authority really be expected to shut down a large "non bank" financial player? He seemed well aware of the shortcomings and delicate issues involved with any regulatory proposals. Some of his interesting (radical?) views can be found here.

He has quite the sense of humour too, I must say. On Goldman Sachs and conflict of interest he said that GS reminded him of an apple (possibly NYC) full of worms. GS is so intertwined in the finanical sector that every trade they make is a conflict of interest.

The best part, however, was when during one of his explanations, a cell phone started ringing softly. He stopped talking and looked around, but soon discovered that the offending piece was his own. So he leans back in his chair and slowly pulls the phone out of his pocket. He opens it, brings it slowly to his ear and with a deadpan delivery barks out: "Let them fail!" ...and then immediately hangs up.

I nominate Volcker to head the resolution authority!

Why Greece is Worth Saving (?)

According to CNBC News, the answer is here: Greek Bailout Deal Closer.

So it looks like we're talking about a $146,000,000,000 bailout (Greek population is around 11,000,000). Who knows what these numbers mean...except to say that they are large.

In return, the government is promising "enormous austerity measures" (tax hikes, wage cuts, etc.).

But why is Greece worth "saving" at all? Well, I love this part. The reporter says "Well just look around...Greece is a huge export market for Germany...just look at all the Mercedes, BMWs, and Audis parked around here!!" (He is in Greece, with the Parthenon in the background as he is saying this).

Now, just hold on there a sec and let's see if I have this right.

German workers bust their butts manufacturing automobiles. Rather than ride them around themselves (an act of consumption), they prudently decide to export all these fancy cars to Greece (an act of saving). Greeks can't manufacture these automobiles themselves (or produce enough olive oil to pay for them) because...well, you know...you can't do this and expect to maintain a decent tan, perhaps. So, the Greeks borrow the cars (an other goods, of course, like suntanning lotion and skimpy German-made thongs perhaps). Greece issues a collective IOU to pay for these things.

But now Greece is having trouble paying back its debt to the Germans. If they default, they won't be able to afford any more German-made automobiles! The German export market will dry up, leaving German auto workers idle!

And to prevent this from happening, the German government stands prepared to tax its citizens to pay for (or at least subsidize) Greek debt, i.e., the German cars it sends to Greece...so that German workers can retain the privilege of working hard and shipping even more cars to Greece? What is this guy thinking (he is not the only one I hear speaking in this way)?

I don't get it. But then again, perhaps this is one reason why I don't get calls from CNBC soliciting my opinion!