Summary press release here. More details to follow.
Archive for the ‘Monetary policy’ Category
The details for the calibration of the EU-wide bank stress test are now available. Looking only at Ireland, and only at one of the key variables in the stress test, the calibration looks problematic. It may be coincidental that the Irish adverse scenario has been badly chosen; it might be that all the other member countries have reasonable calibrations. If the others are as problematic as in the Irish case, this is not a reliable EU banking sector stress test.
Under the adverse scenario, Irish property prices are assumed to suffer a cumulative three-year drop of 3.03%; equivalent to a decline of 1.02% each year for three years in a row. Over the period covered by CSO data, 2005-2013, Irish residential property prices had an annual sample volatility of 11.7%. This in turn implies (under reasonable assumptions) a three-year volatility of 20.27%. In risk analysis it is conventional analytical shorthand to measure adverse outcomes in “x-sigma” units defined as the outcome as a multiple of the standard deviation. For an adverse scenario calibration, the assumed outcome is usually roughly a two-sigma or three-sigma event. Using a four-sigma shock would not be unusual (due to fat tails in some probability distributions). The EBA has calibrated the adverse price shock as a 0.1492-sigma event. That is not credible as an adverse scenario in a stress test.
Keep in mind that the stress test is meant to reassure market participants that even in an adverse scenario the Irish banks are sound. This test reassures us that if property prices fall by as much as one percent a year over the next three years, the banks have enough capital. In the case of a two-percent fall, there are no promises.
As a caveat, this does not mean that the Irish banks need equity capital. They have already had a credible stress test (in 2011) and a big capital injection. Also, the Irish property market although very volatile has a maximum likelihood price change which is positive over the next three years. However the asset class also has considerable “downside” potential and continued high volatility. Conventionally, at least in the case of portfolio risk analysis, the unconditional mean of a stressed variable is set equal to zero for risk analysis purposes. The EBA has chosen to build in a big positive benchmark price rise for Irish property assets, and this is part of the reason that the adverse scenario is unacceptably mild. In any case, this calibration is extremely mild as an adverse scenario and not reassuring for the EU-wide test.
Fiona Muldoon, Director of Credit Institutions and Insurance Supervision at the Irish Central Bank, gave a speech yesterday in Glenties at the MacGill summer school (h/t John Gallaher). The topic of the speech was “Restoring Confidence in the Irish Financial System.” Ms Muldoon gave a fairly upbeat assessment of progress. I am less sanguine. The problem is not lack of international confidence in Irish banks and businesses, but rather lack of international confidence in Irish financial regulation. It is still not clear if the Irish Central Bank has the backbone for the tough tasks it faces in the current environment.
It is important to remember that the weak regulatory stance of the Irish Central Bank during the credit bubble period was one of the chief causes of the Irish economic crisis. The Irish Central Bank’s soft and timid approach, and its willingness to be swayed by political and business interests, was a major cause of Ireland’s economic disaster (for evidence, see my paper with Brian O’Kelly). Has the Irish Central Bank sufficiently altered its approach?
The Irish Central Bank has reformed enough so that if the challenges of 2002-2008 ever reoccur, it will be ready for them. This new resolve to block credit bubbles is not likely to be tested for many decades. The Irish Central Bank needs to have the strength and fortitude to deal with the very different challenges of 2013.
The Irish Central Bank showed no leadership during the fiasco of the 2009 Land Reform Act/Dunne Judgement. The previous government (perhaps deliberately) slashed a gaping hole in Irish financial contract law when it passed the flawed 2009 Land Reform Act. The flaw was pointed out by Justice Dunne, and the judiciary reasonably expected that such an egregious flaw (called a “lacuna” in legal parlance) would be fixed by amending legislation. However the legal flaw was politically convenient since enforcing mortgage contracts would have been politically painful at the time. Ignoring the Dunne Judgement and leaving the flaw in place was very poor practice in terms of restoring international confidence in the Irish financial system, but it was politically convenient for a domestic audience. The government did nothing at all about this legal flaw, despite the obvious impact on Ireland’s international reputation.
It took outside interference by the Troika to get this legal flaw fixed. The Troika repeatedly noted the unacceptable situation in their quarterly reviews, and when government action was still not taken the Troika demanded that the Irish government act by an imposed deadline or face a cut-off in national debt funding. Throughout this long, confidence-draining saga, the Irish Central Bank stood meekly by and said nothing. A stronger-willed central bank (US, UK, Germany, others) would have been screaming from the rooftops about the need to fix such a gaping hole in the country’s financial contracting law. It is not to the credit of the Irish Central Bank that we needed Troika intervention to get this problem acknowledged and fixed.
The Central Bank’s response, or lack thereof, to the explosive growth in mortgage arrears is another case where its stance was timid. Even by late 2011 it was obvious to hard-headed observers that some substantial fraction of the mortgage arrears explosion could be traced to strategic behaviour by households. Mentioning strategic default is offensive to many people since it means acknowledging that some Irish people are acting dishonestly in their own self-interest against the interests of society. A few people were brave enough to mention the obvious (take a bow, Karl Deeter!) but none at the Irish Central Bank. Up until early 2013, the Irish Central Bank effectively had a ban on any mention of strategic default by any central bank spokesperson. This gave rise to some stilted presentations, where Central Bank senior spokespeople railed about the explosion in mortgage arrears without any mention of one of the key causal factors. This omerta was finally broken by Patrick Honohan in early 2013. That was too late in the process to be an international confidence-booster. A strong imperative by the Irish Central Bank not to cause anyone any offence is not a good foundation for building international confidence in Irish financial regulation.
On the positive side, the Irish Central Bank’s actions against Quinn Insurance were tough and bold. So the bottom line is that in terms of restoring confidence the Irish Central Bank has a mixed record over recent years.
The Eurozone banking system is not working properly due to fragmentation between core and peripheral banking systems. In a recent speech, the president of the ECB, Mario Draghi, has acknowledged this, but argues that fixing this problem is someone else’s responsibility. The ECB has the tools to address this crucial flaw in the Eurozone system, and over the medium term horizon there is no other Eurozone institution that can. The ECB should use the tools available to fix this market fragmentation, in particular, the ECB should engage in aggressive, long-term asset refinancing on sufficiently generous terms to encourage bank participation. (more…)
Call for Papers
Bank Resolution Mechanisms
A joint academic-practitioner conference with the theme Bank Resolution Mechanisms wil be held in Dublin, Ireland on Thursday May 23rd, 2013, organized by the Financial Mathematics and Computation Cluster (FMCC) at University College, Dublin and the Department of Economics, Finance & Accounting at National University of Ireland Maynooth. (more…)
Six months ago on this blog I made a quasi-prediction that the number of new residential mortgages in Ireland might shrink to zero-plus-noise. Arguably this has now happened. I claim no great insight and concede that it might have been dumb luck. My quasi-prediction was based on some informal liquidity-risk analysis of the Irish banks. The banks are in a corner solution with respect to long-term illiquid assets. There is little good reason for an Irish-domiciled bank to issue a new residential mortgage, rather, they might be keen to sell any of their existing long-term illiquid assets at a loss. This has only second-order policy importance relative to Greece, etc., but is worth documenting.
The most recent Final Conference to Save the Euro ended in disarray when the UK refused to sign up to a proposed set of EU treaty changes. The UK’s veto was due to the inclusion of an EU-wide Tobin Tax on security transactions in the set of proposals. The justification for an international Tobin Tax is quite strong. Hypercompetitive securities markets with excessively-large trading volumes and hyper-fast price changes are a serious danger to global financial stability. A Tobin Tax would eliminate these dangerous trading excesses without impinging much on underlying market efficiency. On other hand, the UK government’s refusal to sign up to an EU-only Tobin Tax, imposed on the City of London while the US and Asian global financial centres remain outside the tax net, was an obvious and sensible policy decision for the UK.
After the proposed EU treaty changes were restricted to a coalition of the willing, the Irish government fretted that a Tobin Tax might particularly disadvantage the Irish financial services industry, given that the UK will be outside the tax net.
What should be Ireland’s policy stance toward an international Tobin Tax? Should Ireland do the right thing as a global citizen by supporting such a tax within the Eurozone, or should it protect its international financial services industry from UK (and non-EU) predation and therefore veto any such tax proposal? It would be much better for all concerned if the Tobin Tax could be imposed at a global rather than EU level.
Sometime in the future, May 6th 2010 might rank with August 9th 2007 as a “warning date” for a subsequent financial market disaster. Recall that starting on August 9th 2007, quant-trading hedge funds experienced an extremely turbulent, credit-market-related meltdown. Although the quant-trading markets calmed down after about two weeks, many analysts now recognize this as an early warning signal of the subsequent global credit crisis. In an interesting parallel, on May 6th 2010, high-frequency trading systems generated a “flash crash” of US equity markets, causing a 9% fall and 9% rise of the US stock market within a 20 minute period. Some individual stock prices went bananas; completed trades at crazy prices during this short “flash crash” period were annulled that evening by the NYSE board. Since the markets righted themselves within a day or two, many analysts have forgotten about this incident. But could this “flash crash” be an early warning sign of a subsequent “permo-crash”? High frequency trading (HFT), using entirely computerized systems to trade at hyper-second frequency, now constitutes 70% of US equity and equity-related (equity baskets, futures, options) trading volume, and 30% in the UK. If HFT generates a flash-crash at the end of the trading day, rather than mid-day as on May 6th, and something else goes wrong at the same time, it could lead to an enormous disaster.
Tobin originally proposed his tax for the foreign exchange market, which was the first financial market to have hyper-competitive trading costs. He saw that most of the trading volume in forex markets provided very little economic value. A small tax would have a big influence on trading volume, rendering purely speculative and potentially destabilizing trading strategies unprofitable, while having little or no impact on the real economic value of these markets. Tobin called it “throwing sand in the wheels” of securities market trading. Nowadays, Tobin’s “sand in the wheels” metaphor is widely misunderstood. Tobin was a World War Two naval officer and throwing sand in the wheels was an accepted way to improve machine performance in his day. For mid-twentieth century machinery a little sand in the wheels would slow down the mechanism (think of something like a navy ship’s water pumps) and make for more reliable performance with less chance of overheating. With modern precision engineering the notion of “sand in the wheels” as a repair method seems ridiculous, so commentators assume Tobin is advocating sabotage of securities markets. That was not what he meant – “sand in the wheels” is an old-fashioned procedure to slow down machinery so that performance improves, not a means of sabotage. Oddly, the tax is designed to generate minimum revenue – it relies on the elasticity of trading volume to net costs, and tries to drive out destabilizing short-term trading strategies while collecting minimal tax revenue.
Now, after decades of hard-fought liberalization, US and UK equity markets have the same hyper-competitive trading costs as forex markets. HFT has hijacked this and feeds off this market cost improvement (and by earning net profits from “normal” market traders) with trading systems that add little real efficiency improvement for markets. Eliminating their net profits with a small tax would do little harm, and make markets safer. The very bright computer scientists who run these HFT firms could go back to socially useful activities like designing better software.
There is another interesting parallel to the global credit crisis. US housing regulators worked for thirty years to increase access to owner-occupied housing for lower and middle income households and this was a big success. Then, they took that policy too far, and the policy was hijacked by self-interested actors in the US property lending and securities trading sectors. There was too much of a good thing in terms of the too-low-credit-quality US residential property lending market. The same applies now with securities market trading costs and trading access. Regulators have succeeded in driving out bad securities trading practices and greatly lowering trading costs, but this process has gone too far. It has been hijacked by HFT. I call this the Too Much of a Good Thing (TMGT) theory of regulatory capture.
During the credit bubble, Ireland enthusiastically joined the dumb-down contest to impose the minimal possible regulation on the financial services sector. Perhaps now Irish policy leaders could make amends by joining the push for a Tobin Tax.
How would a Tobin tax impact the competitive draw of Dublin for its brand of “off shore” financial services? Perhaps it would be the death knell for the Irish stock exchange since all trading volume might migrate to London. Ireland policymakers should encourage a global solution, bringing the US and UK in particular into the plan. Asian markets (which are not yet competitive for HFT) might be willing to cooperate as well, since there is no great cost for them.
The latest attempt by the ECB to get a grip on the Eurozone crisis might work. It has the potential both to push sovereign market yields toward sustainable rates, and to block self-fulfilling institutional bank runs in which corporate deposits move to stronger Eurozone countries, draining weaker member banking systems of liquidity and credit.
Colm McCarthy was keen on a “reverse tap” in which the ECB enforces a maximum yield (minimum market price) on Italian/Spanish/etc sovereign bonds using its money-creation potential to back up this policy. The problem with his plan, in my view, was the lack of a surveillance mechanism to ensure the funded countries were continuing their needed restructuring. Germany would not accept that solution. My own preference was for the IMF to serve as conduit for sovereign funding via official IMF programs backed by ECB-funded bonds. Colm criticized this as an unnecessary intermediation by the IMF in a problem that needed to be solved by Europe.
The new ECB unlimited-three-year bank funding strategy uses the banks themselves as the monitor for sovereign discipline. It also provides direct bank liquidity so that the slow-motion institutional bank run phenomenon is less likely to lead to the negative feedback loop (corporate depositors distrust the PIIGS banks, PIIGS banks lose liquidity and restrict credit flow to their national economies, PIIGS national economies slow down due to shortage of credit, PIIGS banks suffer due to national economic slowdowns). Actually the “G” does not belong in this acronym anymore since it is a separate case. Perhaps PISI? Commercial banks in the PISI who lose corporate deposits to Germany or elsewhere can replace them with even cheaper funding from the ECB.
Might the new ECB strategy work?
By Richard TolTuesday, December 6th, 2011
The exchange rate is 1:1 Euro:Guilder. That’s a lot better than the 1:2.2 fixed in 1999.
So far, the new/old currency is accepted in a few localities only.
The Financial Regulator, Matthew Elderfield, received a clamour of popular support recently when he publicly objected to the Irish domestic banks planned decision not to decrease variable mortgage rates in response to the ECB cut in interest rates. The political establishment was warmly enthusiastic for Elderfield’s intervention. The government used its shareholding and political muscle to ensure that the banks’ decisions were reversed. The government also offered to provide the financial regulator with legislative power to determine banks’ mortgage rates. Wiser heads within the Central Bank prevailed, and the government was told by the Central Bank “thanks, but no thanks” for the offer of new legal power to set retail mortgage rates. (more…)
The Eurocrats are anxious not to waste the current debt crisis. In today’s Financial Times, Manfred Schepers of the European Bank for Reconstruction and Development proposes not one, but two new EU institutions, to be staffed by transfers from the senior civil services of member states, and promotions within the Brussels/Frankfurt bureaucracies. There will be a new European Monetary Fund, taking on the roles of the International Monetary Fund managing troubled sovereigns, but working on a permanent rather than temporary basis within the Eurozone. Then there will be a new European Debt Agency, managing debt issuance and deficit control for all member states. At a minimum, Schepers’ proposal will aid the Brussels and/or Frankfurt commercial real estate markets, since these bodies will need a lot of office space.
Schepers is keen to retain the ECB’s restricted mandate as a central bank without the ability to engage in quantitative easing, restricting its work to commercial bank liquidity provision and inflation control. He holds this view despite the growing evidence that this central bank design does not work, and the alternative, more flexible mandate of e.g., the Bank of England and US Federal Reserve, does work.
Much more sensible are the views (via a skype video) of Jeff Sachs suggesting that the IMF, together with a reformed ECB acting as a lender of last resort, be brought in to restore stability and confidence to the Eurozone, in the interests both of Europe and the world economy. We also get a glimpse of Professor Sachs’ chi-chi Manhattan kitchen in the background of the video.
Colm McCarthy and many other commentators want the ECB to print euros to whatever extent is necessary in order to keep essentially-solvent Euro states from being unable to finance their deficits. Colm argues that this ECB-provided unlimited funding back-up can prevent an inefficient coordination-game outcome in which investors flee Euro bond markets … because other investors are doing likewise. Once the unshakeable resolve and money-printing firepower of the ECB is demonstrated clearly, the Euro crisis will diminish, in Colm’s view. Many other commentators, e.g, Gavyn Davies, Mervyn King, numerous Germans, argue that this money-printing solution will just generate an indirect subsidy of wasteful Euro governments by prudent ones, with Euro-wide inflation or eventual ECB capital losses serving as the income-transfer mechanism.
There is some talk in today’s papers of a Eurobond system linked to closer EU control over national finances. The EU’s record for governance of this type of national fiscal oversight is not good, and the core nations are rightly sceptical.
Why not a combination policy? The IMF agrees to run sovereign bailout programmes for any Euro countries as needed, with funding provided via IMF-issued, ECB-purchased bonds. The ECB gets a decent, non-exorbitant yield on all new Euros issued, and the IMF has access to an unlimited supply of Euro funding as needed. The guarantee from the IMF-ECB that Italy, Spain and France could be brought within this bailout process as needed, with no funding limits, would probably eliminate the need to bail them out at all (via the same “good equilibrium” mechanism that Colm suggests). To make it credible this programme would need to be ready to activate as needed without exception. Recalcitrant Euro governments who failed IMF programme criteria would be booted from their bailout programmes in the normal way.
Reuters reports that, because Ireland will likely need more financing, it is downgrading Ireland’s credit status to Ba1–of questionable credit quality. The expectation is that there are further falls to come as the prospect of burden sharing, refinancing, or some other combination of unpleasant events, looks increasingly likely. RTE report that the Department of Finance think this is a ‘disappointing development’. Me too.
I’m interested in commenters’ reactions to this news. Does it matter? Is it a sign of things to come?
Colm was right when he said we should fasten our seatbelts.
LBS’s many fans on this Blog will want to read about the controversy surrounding his continued membership of the ECB’s Executive Board. If he does not step down Nicolas Sarkozy is threatening to block Mario Draghi’s accession to the Presidency. The Financial Times account is here.
Silvio Berlusconi has called on him to step down, although no definite decision has been taken to offer him the post as head of Banca d’Italia in succession to Draghi.
According to the Corriere della Sera LBS had ‘no comment’ about the issue on leaving the palazzo Chigi. However, La Repubblica quotes him (on leaving a conference in the Vatican) to the effect that he cannot be removed before the end of his eight-year term. He underlined that ‘personal independence is one of the doctrines on which the independence of the Bank rests.’
Hans-Werner Sinn replies to his critics in relation to Target 2 balances here. Readers of this blog will undoubtedly draw their own conclusions. At the heart of his fallacy is the conceptual absurdity of separate regional credit policies in a monetary union with perfect capital mobility.
Doug Irwin provides a nice account of the historical links between exchange rate and trade policy here.
See the following contribution here from Hans-Werner Sinn. It is certainly original but frankly alarmist. It focuses on the fact that National Central Banks within the euro system are lending bilaterally to each other though without changing the monetary base as a whole. Sinn jumps from there to draw apparently worrying conclusions: that these are “forced capital exports”; that they are the counterparty to current account deficits and that “the PIGS would have had a hard time finding the money to pay for their net imports”.
There is not a scintilla of evidence that the private non-bank sector in the PIGS has lost access to normal European financial markets. If the Bundesbank lends to the Central Bank of Ireland, it does not, in any sense, expand the availability of credit to the private non-bank sector in Ireland. Similarly, German households and firms do not suffer a credit contraction. This is, of course, because there is free movement of capital within the single currency area.
The second non-sequitur in Sinn’s article is the association of accumulated current account deficits in the PIGS with these bilateral loans. Ireland has, of course, a current account surplus so the point is completely irrelevant to at least one of the PIGS. Sinn notes that Italy has not availed of these inter NCB loans, despite its current account deficit, but mistakenly attributes this to virtuous policy on the part of the Italian authorities! It is of course because Italy so far has not yet suffered from a banking or sovereign debt crisis. And for no other reason.
My suspicion is that Target 2 credit is ultimately guaranteed by the ECB: that the Bundesbank loans to the Central Bank of Ireland should be considered as contingent items on the ECB balance sheet. In short, that Target 2 credit is simply a mechanism for implementing ECB policy. But I remain to be corrected on this.
Paul Krugman has a thoughtful survey of the Euro crisis in this week’s New York Times Magazine (forthcoming on Sunday but available on-line now). This is not stockbroker-economist-type research, which tends to be long on buzzwords and hyperbole. It is a well-reasoned feature-length review with some policy suggestions. It has a central focus on Ireland and the other troubled peripheral states.
By Richard TolFriday, December 10th, 2010
There are obvious difficulties and constraints on monetary policy in the 16-member Eurozone compared to more fully integrated currency zones like the fifty states of the USA, the ten provinces of Canada, etc. But could the lack of integration in the 16-member eurozone be used advantageously for some types of policies? (more…)
By Richard TolTuesday, November 23rd, 2010
Over a VoxEU, Stanley Black suggests a way of breaking the EMU without breaking the Euro.
This is a very useful primer on interwar protectionism by the leading historian of US trade policy. (I had never heard of ‘Smoot Smites Smut’, which is worth the price of admission alone.) Although Doug could have usefully mentioned that the biggest costs of protectionism then were geopolitical, and those ended up being fairly catastrophic.
Economists sometimes assume that the right way to talk about protectionism is to moralize. I prefer analyzing the causes of protectionism: it may be a very bad idea, but sometimes, in democracies, it becomes inevitable. Doug, in a manner reminiscent of Adam Posen, argues that expansionary monetary policies in the US are a good way of keeping the protectionist wolf at bay there right now. The same logic applies to Europe as well.
Last week’s news was terrible, but I felt even more depressed the week before. If we enter a spiral in which we get worse news on GDP and GNP than expected, and then conclude that we will have to push through even more deflationary budgets than previously planned, then we have entered a doom loop from which there is no escape.
Unless the cavalry comes charging to the rescue, is what. Unless Ireland is bailed out economically by the rest of the world, via a world trade boom that allows us to export our way to recovery.
Unfortunately, there are lots of question marks hanging over this scenario right now. The cavalry is uncertain as to where it is headed, and for every piece of good news we get from overseas, there is a corresponding piece of bad news (and vice versa). Any honest forecast of where we are headed in the immediate future will have extremely wide confidence bands associated with it, which in the Irish case will surely straddle the zero axis.
This is why it is so utterly in Ireland’s interests that policy makers overseas listen carefully to Adam Posen (short version here, longer version here). I strongly urge people to read the full speech. It is a carefully argued (and, for a central banker, passionate) plea for further stimulus measures, as well as for a certain way of thinking about the macroeconomy. It is nice to know that some central bankers, at least, understand how serious are the downside risks facing the world economy right now.
I am sure that our political leaders enjoyed their moment in the sun this spring as poster boys for austerity. But insofar as they contributed to a feeling that austerity was the right policy everywhere — and not just in basket cases like Greece and Ireland — they did their country a disservice. Far better to have a quiet word with their colleagues in more solvent states, pointing out to them our nine successive quarters of shrinking real GNP, and to say to them: this is what austerity can do, even in an economy as small and open as ours. Are you really sure you want to follow suit?
By John McHaleWednesday, June 23rd, 2010
There is an extensive interview with Olivier Blanchard on the IMF website, and a link to his recent paper on the future of macroeconomic policy making (co-authored with Giovanni Dell’Ariccia and Paolo Mairo), here. I can see this one ending up on lots of undergraduate reading lists.
Update: Krugman likes the paper, which makes sense. He alo cites a completely different argument in favour of moderate levels of inflation, which made quite a splash a few years ago: given that it is hard to cut nominal wages, inflation can be very useful in lowering real wages, when that is what is required.
Real wage reductions are required in Ireland, but nominal wage reductions remain elusive here, despite the spin. Can anyone doubt that Irish real wage adjustment would be easier if we could rely on higher inflation rates to do the bulk of the work?