"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Thursday, January 6, 2011

Really good links - Barro on Bernanke - Rubin's strong dollar legacy - Minsky bailout - Selection and insurance - New orders - Mutual funds vs. ETFs

Robert Barro interview - Ben Bernanke, Great Depression and Lehman Brothers (H/T Marcus Nunes) - "I think they made a big mistake by not bailing out Lehman Brothers – I think they recognized that two days later. That was Paulson’s individual fault and responsibility from what I can gather. <..>
        Q: So what else should I be reading on the Great Depression? A: There’s Ben Bernanke’s research in the 1980s – that’s probably his most important contribution in terms of macroeconomics and financial economics.
        Yes, I saw the Dow Jones Newswires quote on Bernanke’s book, Essays on the Great Depression, which made me laugh: “With some observers saying that the ongoing financial crisis could be the worst since the Great Depression, the greatest living expert on that period is getting the chance to apply its economic lessons.”
        Well Bernanke was thinking that way in April 2008. I remember talking to him at the time, just after the Bear Stearns initial intervention. I got a chance to ask him a question about why they were so aggressive at that time when things didn’t look so bad. And his response was that basically he was worrying about a Depression-type scenario – and trying to act early to nip that in the bud.
        Q: So what is the thrust of his book and why is it important? A: It’s focusing on the Great Depression as a credit implosion, not so much the money supply, which Friedman and Schwartz had emphasized, but a somewhat related phenomenon, which is credit availability. That had been imploding from 1929 through to the trough, early in 1933. So it’s really focusing on the credit aspects and trying to measure that, particularly by looking at patterns in interest rates.
        Today, for example, if you look at the spread between lower quality bonds – like B-rated corporate bonds, say – and compare those to treasury yields, that’s a good indicator of the extent of stress in the credit markets. And actually the recent period is going back to the kinds of spreads that you saw in the early 1930s. Well, perhaps not quite as much, but certainly reminiscent of that. So he’s focused on that as a measure of the extent of the credit stress, and on the other side he focused on how what turned things around was when the credit problems were being eased."

Tim Duy - Rubin's strong dollar legacy - "[W]hat I believe was a central element of the Rubin agenda, and an element that was in fact the most disastrous in the long run - the strong Dollar policy.
        The strong Dollar policy takes shape in 1995. At that point, Rubin made it clear that the rest of the world was free to manipulate the value of the US Dollar to pursue their own mercantilist interests. This should have been more obvious at the time given that China was last named a currency manipulator in 1994, but the immensity of that decision was lost as the tech boom engulfed America.
        Moreover, Rubin adds insult to injury in the Asian Financial Crisis, by using the IMF as a club to enact far reaching reforms on nations seeking aid. The lesson learned - never, ever run a current account deficit. Accumulating massive reserves is the absolute only way to guarantee you can always tell the nice men from the IMF and the US Treasury to get off your front porch.
        In effect, Rubin encourages the US to unilaterally enact a new Plaza Accord on itself."

Hyman Minsky - Minsky bailout - "The lender of last resort must intervene promptly and assure the availability of refinancing to prevent financial difficulties from turning into an interactive cumulative decline that could lead to a great depression. <..> The need for lender-of-last-resort operations will often occur before income falls steeply and before the well nigh automatic income and financial stabilizing effects of Big Government come into play. If the institutions responsible for the lender-of-last resort function stand aside and allow market forces to operate, then the decline in asset values relative to current output prices will be larger than with intervention; investment and debt financed consumption will fall by larger amounts; and the decline in income, employment and profits will be greater.<..>
        Even though the lender-of-last-resort function of the Federal Reserve was of vital importance in stabilizing the economy in 1966, 1969-70, 1974-75, and 1981-82, this function and operations it entails are poorly understood. A lender of last resort is necessary because our economy has inherent and inescapable flaws that lead to intermittent financial instability.<..>
        The creation of a lender-of-last-resort function was a major objective of the legislation establishing the Federal Reserve System in 1913, but that original objective was subverted by a view that the primary and dominant function of the Federal Reserve System is controlling the money supply. <..> Because the Federal Reserve has the responsibility, so to speak, to pick up the pieces when things go wrong, it must be concerned with and guide the growth and evolution of financial practices in periods of tranquility as well as when circumstance forces it to intervene."

A Fine Theorem - Insurance, adverse selection and advantageous selection - "But what of the case where people with lower risk are the ones demanding more insurance, or “advantageous selection”?
        Consider long-term care insurance. The type of people who buy a lot of such coverage are also likely people who are thoughtful and careful in other areas of their life, and hence people who will have lower long-term care costs otherwise. In such a case of advantageous selection, we avoid the usual informational problems. How true is this empirically? <..> In some markets, these two empirical facts combined can tell us why adverse selection does not destroy the market: in the standard adverse selection story, more life insurance is demanded by those who know they will die sooner, but because of heterogeneity is preferences for risk, those who live longer also turn out to be those who demand more life insurance. "

Annaly Salvos - Manufacturers’ new orders

Sandeep Baliga - Mutual Funds vs. ETFs - "First, ETFs are cheaper than the corresponding mutual fund so the first puzzle is why mutual funds are not driven out by ETFs. This is one answer: there is demand for mutual funds from people with self-control problems and in fact they are willing to pay to commit. There is a value to commitment.
        Second, investors who think they cannot beat the market but believe they have self-control should buy ETFs. If their belief in their self-control is na├»ve, they will trade anyway and get worse returns than investors who bought mutual funds.<..>
        There is a value to commitment but there is also a value to self-knowledge: recognizing your self-control helps you to know that you should commit and if you commit, you will lose less money."

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