Credit Default Swap Myths
Peter Wallison tackles the many myths surrounding the role of credit default swaps in the financial crisis:
One conventional explanation for the Bear rescue has been that CDSs made the financial markets highly “interconnected.” It is in the nature of credit markets to be interconnected, however: that is the way money moves from where it is less useful to where it is most useful, and that is why financial institutions are called “intermediaries.” Moreover, there is very little evidence that Bear was bailed out because of its involvement with CDSs—and some good evidence to refute that idea. First, if the government rescued Bear because of CDSs, why did it not also rescue Lehman? If the Treasury Department and the Federal Reserve really believed that Bear had to be rescued because the market was interconnected through CDSs, they would never have allowed Lehman—a much bigger player in CDSs than Bear—to fail. In addition, although Lehman was a major dealer in CDSs—and a borrower on which many CDSs had been written—when it failed there was no discernible effect on its counterparties. Within a month after the Lehman bankruptcy, the swaps in which Lehman was an intermediary dealer were settled bilaterally, and the swaps written on Lehman itself ($72 billion notionally) were settled by the Depository Trust and Clearing Corporation (DTCC). The settlement was completed without incident, with a total cash exchange among all counterparties of $5.2 billion. There is no indication that the Lehman failure caused any systemic risk arising out of its CDS obligations—either as one of the major CDS dealers or as a failed company on which $72 billion in notional CDSs had been written.
posted on 08 January 2009 by skirchner in Economics, Financial Markets
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Macro Non-Predictions for 2009
Macro Man’s non-predictions for 2009.
Macro Man’s strike rate for 2008: 7/10.
posted on 08 January 2009 by skirchner in Economics, Financial Markets
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Commodity Prices and the Australian Economy: Trends versus Cycles
I have an article in the latest issue of Policy examining trends and cycles in commodity prices. In the article, I highlight the difficulty of isolating longer-run trends from the pronounced multi-year cycles in commodity prices. I also argue that commodities are not nearly as important to the Australian economy as commonly assumed.
posted on 07 January 2009 by skirchner in Commodity Prices, Economics
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What is Seen and What is Not Seen: Cow Candy Edition
From the office of the Treasurer, Wayne Swan:
Today I visited the Biocane Mill at Bli Bli on Queensland’s Sunshine Coast and announced the reinstatement of a $1 million funding grant to help complete the construction of a factory at the site.
The company, Biocane Ltd, will use the factory to manufacture stock feed from sugar cane using technology pioneered in Australia that produces a dry sweet fodder, known as ‘Cow Candy’, which is exported to cattle feedlots in East Asia…
The Minister took an active interest investigating this issue because he understands how important it is to support local businesses and has now reinstated the funding.
Biocane Ltd has advised that it will employ 32 people at the Bli Bli plant to complete the construction and upon completion about 18 permanent jobs will be created initially at the mill, as well as flow-on employment for sugar cane farmers and their employees.
Having grown up at Nambour I know first hand how important this funding will be to the sugar cane industry and the economy of the Sunshine Coast region.
Pity they didn’t teach Bastiat at Nambour High:
But the disadvantage that the taxpayers try to free themselves from is what is not seen, and the distress that results from it for the merchants who supply them is something further that is not seen, although it should stand out plainly enough to be seen intellectually.
When a government official spends on his own behalf one hundred sous more, this implies that a taxpayer spends on his own behalf one hundred sous the less. But the spending of the government official is seen, because it is done; while that of the taxpayer is not seen, because—alas!—he is prevented from doing it.
posted on 06 January 2009 by skirchner in Economics
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Blame Oil, Not Housing
Amid the GFC of 2008, it was easy to forget that 2008 also saw a major oil price shock. In a series of posts, James Hamilton argues that the oil price shock largely accounts for the downturn in the auto sector. He also presents evidence to suggest that the oil price shock was critical in exacerbating the downturn in the housing sector.
Hamilton concludes that ‘if gasoline prices had stayed at $2.50 a gallon through 2008, the NBER Business Cycle Dating Committee would not have declared that the current recession began in December 2007.’
posted on 04 January 2009 by skirchner in Economics, Oil
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Right Forecast, Wrong Trade
The WSJ profiles ‘doomsayers who got it right’ – well, almost:
[Peter Shiff] has been wrong on significant parts of his argument. Many detractors point out that two of his core beliefs—a longstanding prediction that the dollar would collapse and that foreign stocks would outperform U.S. shares—have been well off the mark in this crisis. A rush into the safety of the greenback sent the dollar soaring against other currencies and, as a side effect, helped undermine shares of stocks around the world.
Mr. Schiff acknowledges that he wasn’t expecting that to happen. But he says his worries aren’t misplaced: A dollar dive and foreign-stock outperformance are still in the cards.
posted on 02 January 2009 by skirchner in Economics, Financial Markets
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In Search of the Real Austrian School
Time magazine’s economics columnist Justin Fox goes in search of the real Austrian School:
People in the U.S. who self-identify as believers in Austrian economics, though, tend to follow a much narrower path, that of Mises and his American disciple Murray Rothbard. They are extremely libertarian (at the first meeting of the Mont Pelerin Society, a libertarian group organized by Hayek in 1947, Mises stormed out saying “You’re a bunch of socialists”). They yearn for a return to the gold standard. Many possess a near-religious conviction that their beliefs are correct and that all other economic theories are pure folly. Some of them—I’m thinking here mainly of the crowd around Lew Rockwell—combine these beliefs with far loopier stuff. Others—such as financial pundits Peter Schiff and Michael Shedlock—often let their rabid Austrian leanings overpower (and, to my taste, ruin) otherwise trenchant economic analyses. Am I going to go to these people for perspective on the business cycle or Austrian economics? No, I don’t think so.
On the other hand, I’m not going to do like Krugman and dismiss Austrian economics as “about as worthy of serious study as the phlogiston theory of fire.” Just because something is outside the mainstream doesn’t mean it’s wrong. I guess the best thing for me to do would be for me to read more of the source material myself. I’ve dabbled in Hayek and Schumpeter and even Rothbard. If I devoured all of Menger’s Grundsätze der Volkswirtschaftslehre, in German, that ought to give me a certain authority, right?
That’s not going to happen anytime soon, so I’ll keep relying on Tyler Cowen. I will also try to follow Ransom’s advice, though. Roger Garrison of Auburn and Steve Horwitz of St. Lawrence University, the two modern Austrian-school economists he recommends, seem on first examination to be more interesting than loopy or strident, so I’ll start looking out for their writings. First step, adding the Austrian Economists blog, to which Horwitz contributes, to my feed reader.
posted on 02 January 2009 by skirchner in Austrian School, Economics
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Market-Based Predictions for 2009
Predictions for 2009 derived from people who put their money where their mouth is:
1 GM to announce a merger with another major auto manufacturer: 35%
2 More than US$25 billion to be injected into the big 3 auto-makers: 60%
3 Caroline Kennedy to replace Hillary Clinton in the US Senate: 53%
4 Guantanamo Bay Detention Camp to be closed in 2009: 84%
5 The US in Recession in 2009: 85%
6 An air strike against Iran before end of 2009: 21%
7 US unemployment rate at or above 8% in December 2009: 50%
8 Robert Mugabe to depart as President of Zimbabwe in 2009: 50%
9 Slumdog Millionaire to win Academy Award for Best Picture: 52%
As at 7am EST 12/29/2008.
posted on 31 December 2008 by skirchner in Economics, Financial Markets
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‘Really big, bad things tend to be surprises’
An article on how the economics profession is reflecting on the GFC:
Robert Lucas, an economist and Nobel laureate at the University of Chicago and a champion of the rationality of markets, doesn’t see much fundamental change coming out of the crisis, either. What it has reminded us of, he argues, is simply the impossibility of seeing these events in advance.
“I don’t know anybody involved who thought he could predict these turning points. Do macroeconomists know as much as we thought we did?” he asks. “Of course not.”
By this logic, the problem isn’t how economists see the world so much as it is what we expect of economics.
Laurence Ball, an economist at Johns Hopkins, makes a similar point. “Nobody ever sees anything coming,” he says. “Nobody saw stagflation coming, nobody saw the Great Depression coming, nobody saw Pearl Harbor or 9/11 coming. Really big, bad things tend to be surprises.”
Even Monty Python understood this basic rational expectations insight: ‘Nobody expects the Spanish Inquisition!’
posted on 23 December 2008 by skirchner in Economics, Financial Markets
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Monetary and Fiscal Policy Effectiveness in a Globalised World
Alan Greenspan, interviewed in Die Zeit, on the effectiveness of monetary and fiscal policy:
Global forces can now override most anything that monetary and fiscal policy can do. Long-term real interest rates have significantly more impact on the core of economic activity than the individual actions of nations. Central banks have increasingly lost their capacity to influence the longer end of the market. Two to three decades, ago central banks were dominant throughout the maturity schedule. Thus, the more important question is the direction of long-term real interest rates…
The resources of central banks relative to the size of global forces have markedly diminished. We have 100 trillion dollars of arbitragable long-term securities in the world today so that even large movements initiated by central banks have little impact. Until the seventies, central banks and finance ministries were able to hold exchange rates fairly stable. Since then, the ability to intervene in the exchange markets and stabilize the rates has gone down very dramatically. And that is also true for other financial markets. Global forces fostering global equilibrium have become by far the most dominant influence for financial and economic activity. Governments have ever less influence on how the world works.
The way it should be.
posted on 22 December 2008 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy
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Rent-Seekers Gone Wild: ‘Shovel-Ready’ Edition
Fiscal stimulus rent-seeking is not just for people:
The Association of Zoos and Aquariums (AZA) today called for shovel-ready zoo and aquarium infrastructure projects to be eligible for Federal stimulus funding…
“Zoos and aquariums are woven into the fabric of American life,” said AZA President and CEO Jim Maddy. “They are viewed by the public as important to the quality of life in their communities.”
Many zoos have their roots in the Great Depression, when the Federal Work Projects Administration (WPA) helped build many zoos across America.
“Zoos and aquariums will deliver incredible value for the Federal government,” added Maddy. “Investment in these institutions will pay-off twice, first in immediate job creation, and second, in the environmental education of our children for years to come.”
The same children can also look forward to paying for them for years to come.
Come to think of it, I also have some ‘shovel-ready’ projects in my backyard that could do with some stimulus.
posted on 20 December 2008 by skirchner in Economics, Fiscal Policy
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Fiscal Stimulus Doesn’t Work - Ever
Tyler Cowen suggests the historical record argues against the effectiveness of fiscal stimulus:
it is very hard to find examples of successful fiscal stimulus driving an economic recovery. Ever. This should be a sobering fact…
It’s up to the advocates of the trillion dollar expenditure to come up with the convincing examples of a fiscal-led recovery. Right now we’re mostly at “It wasn’t really tried.” And then a mental retreat back into the notion that surely good public sector project opportunities are out there.
So what you have is the possibility of faith—or lack thereof—that our government will spend this money well.
And that is under “emergency” conditions, with great haste (“use it or lose it”), with a Congress eager to flex its muscle, and with more or less one-party rule.
Another way of looking at this issue is to ask why we would ever need to experience a significant economic downturn if policymakers could effectively smooth the business cycle with fiscal policy.
Meanwhile, Centrebet is offering $1.22 for a local recession by the December quarter 2009. Assuming an 8% bookie’s margin, this implies a recession probability of around 75%. Needless to say, the Treasurer is not happy with betting shops speaking truth to power:
I think that sort of talk is utterly irresponsible.
posted on 19 December 2008 by skirchner in Economics, Fiscal Policy
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Debunking the Lehman Brothers Bailout Myth
John Taylor debunks the myth that failing to bailout Lehman Brothers was responsible for the subsequent intensification of the global financial crisis:
Many commentators have argued that the reason for the worsening of the crisis was the decision by the U.S. government (more specifically the Treasury and the Federal Reserve) not to intervene to prevent the bankruptcy of Lehman Brothers over the weekend of September 13 and 14.
The [LIBOR-OIS] spread moved a bit on September 15th, which is the Monday after the weekend decisions not to intervene in Lehman Brothers. It then bounced back down a little bit on September 16 around the time of the AIG intervention. While the spread did rise during the week following the Lehman Brothers decision, it was not far out of line with the events of the previous year.
On Friday of that week the Treasury announced that it was going to propose a large rescue package, though the size and details weren’t there yet. Over the weekend the package was put together and on Tuesday September 23, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified at the Senate Banking Committee about the TARP, saying that it would be $700 billion in size. They provided a 2-1/2 page draft of legislation with no mention of oversight and few restrictions on the use. They were questioned intensely in this testimony and the reaction was quite negative, judging by the large volume of critical mail received by many members of the United States Congress. It was following this testimony that one really begins to see the crises deepening, as measured by the relentless upward movement in Libor-OIS spread for the next three weeks. Things steadily deteriorated and the spread went through the roof to 3.5 per cent.
…identifying the decisions over the weekend of Sept 13 and 14 as the cause of the increased severity of the crisis is questionable. It was not until more than a week later that conditions deteriorated. Moreover, it is plausible that events around September 23 actually drove the market, including the realization by the public that the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe. At a minimum a great deal of uncertainty about what the government would do to aid financial institutions, and under what circumstances, was revealed and thereby added to business and investment decisions at that time. Such uncertainty would have driven up risk spreads in the interbank market and elsewhere.
Taylor doesn’t say it, but his event study is also consistent with the view that it was irresponsible scare-mongering by the US authorities in support of the TARP legislation that was responsible for the subsequent blow-out in the LIBOR-OIS spread.
posted on 15 December 2008 by skirchner in Economics, Financial Markets
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A Beginners Guide to Oil
A review of Vaclav Smil’s new book, Oil:
The list of big-name economists, commentators and forecasters who hung their hats—and their investment plans—on variations of peak oil theory is too big for this page, but some day somebody should post it prominently for all to see.
One of the rare exceptions, a name not on any such list, is Vaclav Smil, perhaps one of Canada’s greatest unsung academics. Let me now sing his praises. Prof. Smil is a distinguished professor in the environment faculty at the University of Manitoba. One of his many books, usually dense and written for scholars, is a new popular Beginners Guide, simply titled Oil (Oneworld Publications, 200 pages, 2008).
Back in June, 2006, Prof. Smil wrote a commentary for FP Comment dismissing the peak oil crowd as a “new catastrophist cult.” In 2000, he warned in a science journal that the experience of long-range forecasting, especially in energy, had been dismal. He predicted more. “There will be no end to naive, and ... incredibly short-sighted or outright ridiculous, predictions.”
Prof. Smil’s new contribution to the absurdity of peak oil theory, Oil, is more than just a critique of the latest crackpot forecasting theories. In 200 pages, he packs everything most people—including most economists and investment advisors—should know about the physics and economics of oil.
As time goes on the world will slowly sever its dependence on fossil fuels, but any such transition is decades away. Peak oil enthusiasts are wrong for scores of reasons. They assume that oil reserves are know with some degree of precision; that reserves are fixed; that demand and supply can be projected with accuracy over long periods of time.
As Prof. Smil wrote on this page in 2006: “Unless we believe, preposterously, that human inventiveness and adaptability will cease the year the world reaches the peak annual output of conventional crude oil, we should see that milestone (whenever it comes) as a challenging opportunity rather than as a reason for cult-like worries and paralyzing concerns.”
posted on 12 December 2008 by skirchner in Economics, Oil
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Will the Euro Survive the Crisis?
Martin Feldstein asks whether the euro can weather the global financial crisis:
The current differences in the interest rates of euro-zone government bonds show that the financial markets regard a break-up as a real possibility. Ten-year government bonds in Greece and Ireland, for example, now pay nearly a full percentage point above the rate on comparable German bonds, and Italy’s rate is almost as high.
There have, of course, been many examples in history in which currency unions or single-currency states have broken up. Although there are technical and legal reasons why such a split would be harder for an EMU country, there seems little doubt that a country could withdraw if it really wanted to.
The most obvious reason that a country might choose to withdraw is to escape from the one-size-fits-all monetary policy imposed by the single currency. A country that finds its economy very depressed during the next few years, and fears that this will be chronic, might be tempted to leave the EMU in order to ease monetary conditions and devalue its currency. Although that may or may not be economically sensible, a country in a severe economic downturn might very well take such a policy decision.
Intrade puts the probability of an existing member leaving the eurozone before the end of 2010 at 27%.
posted on 11 December 2008 by skirchner in Economics, Financial Markets
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