Back in 2010, as the world turned austerian, people like Adam Posen started to worry about the political consequences. Indeed, so did I. Alan de Bromhead, Barry Eichengreen and I have a new working paper which looks at the political consequences of economic hard times in the 1920s and 1930s, which you can read here.
Category: Political economy
Eoin Reeves and Dónal Palcic write in today’s Irish Times on the issue of privatisation, and they don’t pull their punches. From the piece:
Not only is there a lack of clarity about the companies to be sold and the timing of any sales, but it has also emerged that there are significant differences between the Government and the troika on the role privatisation should play in contributing to any economic recovery. These differences do not bode well in terms of making the best decisions about the future ownership of critical infrastructure industries.
At this stage, two key points of difference between the Government and the troika can be discerned. First, the drip-feed of information provided during the latest visit indicates that the troika views privatisation as a structural reform issue that should be implemented to improve the overall competitiveness of the economy. The Government, meanwhile, appears to be focused on privatisation as a means of raising exchequer revenues.
The second point of difference concerns how the proceeds from privatisation should be used. Whereas the Government wants to direct revenues towards job creation, the troika views proceeds as a means of paying down the national debt.
The troika’s view of privatisation as a tool for reducing costs and improving competitiveness is an orthodox proposition that is traditionally associated with multilateral organisations such as the International Monetary Fund but it is one that can be readily challenged.
Palcic and Reeves finish by making an important point about the dangers of short term political thinking applied to long term strategic assets. This problem is rarely discussed, as far as I can see, in Irish public policy. Hopefully we’ll see some more discussion in the comments about this problem.
The concept of “fire sale prices” is a useful one in many contexts – some examples are the October 19th 1987 US stock market crash, the LTCM crisis of 1998, and the 2007-8 US credit-liquidity crisis. In all three of these cases, security prices crashed in a particular sub-market, policymakers stepped in providing extraordinary credit-liquidity support, and eventually (quickly in the first two cases, slowly in the last) the capital market situation normalized. Unfortunately, “fire sale prices” is a useless or even harmful analytical tool for understanding the current Irish financial predicament. A better term for current conditions in Irish asset markets is stagnation prices rather than fire sale prices. Policymakers should look to Japan circa 1991 and the following two decades, rather than the USA, for a useful historical precedent. The fire sale concept gives the wrong policy guidance in the Irish situation; it is metaphorically like trying to use a fire hose to drain a swamp.
Andrei Shleifer and Robert Vishny have a series of papers exploring the use of the fire sale concept in modelling financial markets. There has been a large outpouring of papers by other authors with similar or related models, but the Shleifer and Vishny model is clear and simple and their survey is particularly good. They provide a definition:
“A fire sale is essentially a forced sale of an asset at a dislocated price…. Assets sold in fire sales can trade at prices far below value in best use, causing severe losses to sellers.”
They discuss how fire sales can cause financial and macroeconomic instability via credit and liquidity channels. In a related paper they laud US policymakers for their prompt and correct response in 2007-9 in injecting massive credit and liquidity into the markets for mortgage-related and credit-related securities caught up in the fire sale environment of 2007-9.
Fire sale mitigation policies are unusual as economic policies in that, as a rule, they should result in a net profit for the policymaker. This follows from the theory of the limits to arbitrage. This certainly seems to apply in the US case – the Federal Reserve made a trading profit of $79.3 billion in 2010 and $76.9 billion in 2011. The Fed vastly outperformed the best-performing hedge fund both years, at U.S. civil service pay rates, and without actually trying to make a profit. TARP was also profitable or near profitable, after an adjustment for the expensive but necessary bail-out of the US automobile industry. This is the nature of fire sale mitigation policies – they are about buying securities slightly below fair value and holding them temporarily on government account while injecting liquidity and credit.
The bad news is that this has near-zero relevance for Ireland. Irish asset markets are not suffering from a fire sale problem but rather from a long-horizon stagnation problem. The appropriate comparison case is not from the USA but rather Japan circa 1990. Japanese policymakers and financial institutions worked endlessly to slow the pace of adjustment, leading to an almost twenty year period of stagnation, suppressing growth and business innovation, and leaving a massive overhang of government debt. Irish asset markets need to be forced to adjust quickly and reach their new (much lower) equilibrium values with un-frozen free trading and clear, public pricing. This applies to banks, collateralized pools of debt, commercial leases, and commercial and residential property. Preventing this from happening is not preventing a “fire sale” rather it is guaranteeing a long stagnation. It could even last twenty years, as in Japan.
Another question – what is it about the US environment that gives rise to fire-sale-induced financial crises of typically short duration? Part of the answer lies in the USA lead in financial innovation. New financial innovations were key to all three fire-sale market crashes mentioned in the first paragraph of this post (portfolio insurance, statistical arbitrage, and numerous CDO innovations, respectively). High-frequency trading (the most recent big innovation) will be the likely cause of the next fire-sale-related crash, if one comes in the USA.* Ireland seems to avoid these fire-sale crashes, but is plagued instead by long-lasting periods of stagnation. Let us hope the current one is not dragged out for a decade.
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*A post-script on HFT and the Tobin tax. After my last blogpost, Frank Barry asked me to give more details about Tobin’s use of the term “sand in the wheels” and its application in old-fashioned engineering. I do not know that much about the engineering use of sand in the wheels – I only heard Tobin discussing it in an interview. I now know that historically the sand in the wheels technique was used in the case of a metal (steel or iron) wheel aligned on a track and needing better grip, such as an old-fashioned railway wheel on a wet track. It is used for wheel-type mechanisms and not for gears with teeth. See Wikipedia for some details for those with an interest. I remember Tobin saying he was annoyed that many commentators mistook him as suggesting sabotage, and I remembered that key idea correctly. Sand in the wheels is a technique to improve, not hinder, performance.
The Minister for Transport, Mr Varadkar, in commenting on whether a referendum will be necessary for Ireland to sign up to the fiscal compact is reported to have made the commonplace point that
There’s only one reason why you have a referendum and that’s where there is a requirement to change the constitution.
Em, not quite.
Apart from a political view that a referendum might be desirable in any event, there is a particular mechanism in the Constitution of Ireland for holding a referendum, even when a measure does not require constitutional amendment. This is set out in Articles 27 and 47, whereby one-third of the Dáil and a majority of the Seanad could petition the President to decline to sign and promulgate a Bill “on the ground that the Bill contains a proposal of such national importance that the will of the people thereon ought to be ascertained.”
The detailed provisions of Article 27 envisage that if such a petition were successful, the will of the people could be ascertained either by referendum (in which at least one-third of those on the register would have to vote “no” in order to veto, by virtue of Article 47) or, in effect, by a general election.
I guess the fiscal compact itself may not in fact be a Bill, but presumably the detailed fiscal provisions of the agreement will have at least that legal form. Apart from whether the required numbers of TDs and Senators would line-up for the petition which Article 27 envisages, whether or not this mechanism will be applicable seems to me, as a non-lawyer, to turn on whether the Bill in question is a “Money Bill”. Money Bills appear to me to exempt from Article 27 (reading back to Articles 23 and 22) but I may be mis-reading that, so perhaps we might get some legally informed views in comments.
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.