Michael Woodford - Inflation Targeting during Credit Market Turmoil

Run, don't walk, to read Woodford's BOE presentation "Inflation Targeting during Credit Market Turmoil".

Key takeaways:

• Central bank policy stance has three independent dimensions:
• quantity of reserves
• interest paid on reserves
• composition of asset side of CB balance sheet (credit easing)
• Zero lower bound is solved by committing to maintain low interest rates for a time, even after it becomes possible to again achieve inflation target without violating the bound.
• Price level targeting is essential during credit crisis
• automatic creation of expectations of reflation
• it is an inflation targeting regime with commitment to error correction
• Credit easing may be optimal in the case of large financial disruptions
• size of credit spreads as a justification for credit policy
• unrelated to whether zero bound on policy rate reached (ECB in August 2007)
• Interest on reserves is desirable during credit market turmoil - for credible exit strategy

Scott Sumner does not agree with Michael Woodford Woodford (and me):

• Sumner says interest on reserves is a key mistake
• Sumner says large financial disruptions can be avoided by credible NGDP targeting - no need for CB credit policy

What I didn't like:

• Woodford says QE doesn't work when treasuries are purchased and when QE is withdrawn when conditions normalize (see Japan 2001-06). But there is a possibility that Japan would be even worse without such QE 
• Joint optimality of three dimensions of monetary policy not considered

Really great links - Financial repression - Four biggest banks insolvent under mark-to-market - Life of a financial speculator - Collective intelligence

Martin Wolf - Financial repression - "What do governments do when it becomes expensive to borrow? They promise to mend their ways, of course. But, by now, it is often too late: nobody believes them. So they tell the central bank to buy their bonds, which starts a run on the currency. Pegged exchange rates collapse and floating exchange rates fall. Inflation becomes an imminent threat.
        At this point, desperate governments look for ways to force institutions to hold their bonds, willy nilly. This is the point at which financial repression begins: banks are forced to hold government bonds, for “liquidity”; pension funds are forced to hold government bonds, for “safety”; interest rate ceilings are imposed on private lending; to prevent “usury”; and, if all else fails, exchange controls are imposed, to ensure nobody can easily escape from such regulations."

Rebel A. Cole and Garett Jones - Big banks back to brink of ruin - "Bank of America, Chase, Citigroup and Wells Fargo - the four largest bank holding companies in America - required massive government aid in late 2008. They barely survived into 2009. Now, somehow, these banks have reported upbeat results in the fourth quarter of 2009 - a shocking turnaround. Or was it?
        Can these bank forecasts possibly be accurate, or have the banks hired Bernie Madoff to perform their forecasts? Sadly, it looks as if Bernie is hard at work, predicting an unrealistically bright future for these banks.
...
        If we're right about these losses, three of the four biggest banks have such bad loan portfolios that they would be deemed insolvent under mark-to-market accounting rules. Only Citi would be marginally solvent, but it has serious problems outside of its loans portfolio that drag it into insolvency as well. One can safely predict that these four megabanks, as well as most other lenders, will lose much, much more on mortgage-related loans than rosy-eyed regulators or the banks themselves are publicly acknowledging"

BBC - A day in the life of a financial speculator - Amusing video about hedge fund manager Hugh Hendry

Matt Ridley - Collective intelligence - "Human evolution presents a puzzle. Nothing seems to explain the sudden takeoff of the last 45,000 years—the conversion of just another rare predatory ape into a planet dominator with rapidly progressing technologies. Once "progress" started to produce new tools, different ways of life and burgeoning populations, it accelerated all over the world, culminating in agriculture, cities, literacy and all the rest. Yet all the ingredients of human success—tool making, big brains, culture, fire, even language—seem to have been in place half a million years before and nothing happened. Tools were made to the same monotonous design for hundreds of thousands of years and the ecological impact of people was minimal. Then suddenly—bang!—culture exploded, starting in Africa. Why then, why there?
        The answer lies in a new idea, borrowed from economics, known as collective intelligence: the notion that what determines the inventiveness and rate of cultural change of a population is the amount of interaction between individuals"

Really great links - Fed - Greece - Debt overhang

Tim Duy - Fed disconnect - "To summarize, the Fed believes we are facing another threat to demand, either via financial or real trade linkages, at a time when lending activity continues to fall, suggesting that monetary policy is too tight to begin with. But the Fed stance is to believe that monetary policy is on the verge of being too loose, and, if anything, planning needs to be made to tighten policy. At the same time, Fed policymakers also believe fiscal policy needs to turn toward tightening as well. Meanwhile, unemployment hovers just below 10%, nor is it expected to decline rapidly, and inflation continues to trend downward.
        All of which together suggests that the Fed's policy stance is seriously out of whack with policymaker's interpretation of actual and potential economic developments. And I have trouble explaining the disconnect."

Crispin Odey (via Jonathan Davis) - Greece - "The shorthand story of Greece (according to Odey) is that this was an economy, not unlike many emerging market economies, in which prior to entry into the EU and more importantly the Euro, tax revenues raised 25% of GNP, the government spent 28% of GNP and the deficit of 3% of GNP was funded by the printing press. The ensuring inflation of 10% meant that interest rates were at 15%. Government debt loitered around 40% of GNP making interest payments equal to 6% of GNP. Stability of a sort prevailed, poverty of a sort held rein.
        The Greeks enter the Euro. The government starts thinking like Brussels. Spending rises effortlessly towards 40% of GNP. Taxes rise to 31%. The shortfall is no longer monetised. Fellow Europeans now buy the debt issued. Interest rates fall to Euro levels. Average cost of debt falls to 5% and the government contents itself that although their debt has risen to 120% of GNP they are still only paying out 6% of GNP in interest payments. Then the lenders finally awake from their happy slumbers and realise that this debt is never going to be repaid. The wake-up call came from the new government denouncing the previous government’s tax revenue numbers."

Baseline Scenario - Debt overhang - "Prime Minister George Papandreou said this week that Greece needs to see strong investment in order for the austerity program to work. While the government cuts fiscal spending, he said, it needs new private business to employ the dismissed workers so that they are productive, can pay taxes and do not need unemployment benefits.
        The problems are strikingly reminiscent of Latin America in the 1980s. Those nations borrowed too heavily in the 1970s (also, by the way, from big international banks) and then — in the face of tougher macroeconomic conditions in the United States — lost access to capital markets. For 10 years they were stuck with debt overhangs, just like the weak euro zone countries, which made it virtually impossible to grow.
        Debt overhangs hurt growth for many reasons: business is nervous that taxes will go up in the near future, the cost of credit is high throughout society, and social turmoil looms because continued austere policies are needed to reduce the debt. Some Latin America countries lingered in limbo for a decade or more."

Really great links - Bernanke and inflation - Greece - Return expectations and volatility

Nick Rowe - Bernanke and inflation - "There’s a true paradox here. Bernanke wants (or ought to want) people to fear inflation. Yet he also wants to argue that the risk of inflation is very low, which is why he needs to keep interest rates low. His only way out of the paradox is to make an argument which is very convincing to people inside the Fed, and is seen by outsiders to be very convincing to people inside the Fed, but is at the same time totally unconvincing to people outside the Fed. Not an easy task."

John Cochrane - Greece - " We're told that a Greek default will threaten the financial system. But how? Greece has no millions of complex swap contracts, no obscure derivatives, no intertwined counterparties. Greece is not a brokerage or a market-maker. There isn't even any collateral to dispute or assets to seize. This isn't new finance, it's plain-vanilla sovereign debt, a game that has been going on since the Medici started lending money to Popes in the 1400s. People who lent money will lose some of it. Period.
        Saving the banks. We're told that Greece must be bailed out, or large banks will fail. Savor the outrageous irony of this claim. Apparently, two years after the great mortgage meltdown, Europe's army of bank regulators missed the fact that large, "systemically important" banks had made firm-threatening bets on Greek debt. So much for the idea that more regulation will keep complex banks out of trouble."

Eric Falkenstein - Return expectations and volatility - "Steve Sharpe and Gene Amromin actually got around this objection by looking at survey data, and found that in questionnaires investors tended to have higher return expectations when they forecast volatility as being relatively low, and lower return expectations when they forecast higher volatility. Exactly the opposite of what they should be thinking. This isn't a missing a constant in the second decimal, rather, screwing up the sign."

Really great links - Financial market frictions - Fiscal policy - Wounded Ireland

Narayana R. Kocherlakota - Modern Macroeconomic Models - "In the preceding section, I have emphasized the development of macro models with financial market frictions, such as borrowing constraints or limited insurance. As far as I am aware, these models are not widely used for macro policy analysis. This practice should change. From August 2007 through late 2008, credit markets tightened (in the sense that spreads spiked and trading volume fell). These changes led—at least in a statistical sense—to sharp declines in output. It seems clear to me that understanding these changes in spreads and their connection to output declines can only be done via models with financial market frictions. Such models would provide their users with explicit guidance about appropriate interventions into financial markets."

Narayana R. Kocherlakota - Fiscal policy - " In terms of fiscal policy (especially short-term fiscal policy), modern macro modeling seems to have had little impact. The discussion about the fiscal stimulus in January 2009 is highly revealing along these lines. An argument certainly could be made for the stimulus plan using the logic of New Keynesian or heterogeneous agent models. However, most, if not all, of the motivation for the fiscal stimulus was based largely on the long-discarded models of the 1960s and 1970s. Within a New Keynesian model, policy affects output through the real interest rate. Typically, given that prices are sticky, the monetary authority can lower the real interest rate and stimulate output by lowering a target nominal interest rate. However, this approach no longer works if the target nominal interest rate is zero. At this point, as Gauti Eggertsson (2009) argues, fiscal policy can be used to stimulate output instead. Increasing current government spending leads households to expect an increase in inflation (to help pay off the resulting debt). Given a fixed nominal interest rate of zero, the rise in expected inflation generates a stimulating fall in the real interest rate. Eggertsson’s argument is correct theoretically and may well be empirically relevant. However, the usual justification for the January 2009 fiscal stimulus said little about its impact on expected inflation."

Morgan Kelly - Whatever happened to Ireland? - "Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.
        Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115 billion of bonds through a partial debt for equity swap."

Really great links - Greece and inflation tax - Investment research - Eurocrats - Structured finance

James Hamilton - Inflation, taxation, and the underground economy - Greece - "Aruoba's interpretation is that the weaker a country's institutions, the greater the attractiveness of the informal sector, and the more the government is likely to rely on inflation rather than standard taxes to raise revenue.
        I was thinking about these correlations as we all ponder the storm clouds over Europe. Joining a common currency unit means losing the ability to adapt monetary policy to your own country's cyclical conditions. But it also means surrendering to your neighbors' long-run mix of formal-sector taxes rather than inflation as a source of government revenue."

Lorenzo Bini Smaghi, Member of the Executive Board of the ECB - Lessons of the crisis: Ethics, Markets, Democracy - "In recent years the use of market information for “promotional” purposes has grown considerably. In the mass media, i.e. newspapers and television, the opinions of the analysts of the major banks are often sought. Since information is scarce and should have a monetary value for a financial market participant, one may wonder why it is made available to all free of charge. One hypothesis is that this contributes to the market participant’s reputation, attracting new clients. But clients should prefer insider information, the information that others do not have. The alternative, more credible, hypothesis is that with their considerable presence in the media market participants seek to steer the entire market, i.e. acting as herd leader."

Nick Rowe - Eurocrats - "A couple of weeks ago, at a Carleton seminar, I put forward the following totally paranoid conspiracy theory: in a bunker somewhere, deep in the heart of Euroland, a group of Eurocrats is breaking out the champagne. "Finally, the crisis we always wanted and predicted when we set up the Euro has happened. Now they will have to create a United States of Europe!""

Alex Tabarrok - The Dark Magic of Structured Finance - "Suppose that we misspecified the underlying probability of mortgage default and we later discover the true probability is not .05 but .06. In terms of our original mortgages the true default rate is 20 percent higher than we thought--not good but not deadly either. However, with this small error, the probability of default in the 10 tranche jumps from p=.0282 to p=.0775, a 175% increase. Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase!
        The dark magic of structured finance conjured many low-risk securities out of many risky securities. Like all dark magic, however, the conjuring came at a price because if you didn't get the spell exactly correct it was easy to create something much more risky and dangerous than you were likely to have ever imagined."
        - from the comments: - "This math assumes that security defaults are independent, which is an assumption nobody ever made. It was not until David Li's seminal work on using the Gaussian copula to model correlations that anyone had any confidence in valuing these securities.
        Unfortunately, tranches, especially safe, senior tranches, are very sensitive to the correlation assumption - even worse than to misspecifications of the probability of default.

Really great links - Liquidity is solvency - Balance sheet contamination - Fiscal policy and current account -

Paul McCulley - PIMCO - Liquidity is solvency - "A banking system is solvent only if it is believed by the public to be a going concern. By definition, if the public’s ex-post demand for liquidity at par proves to be equal to its ex-ante demand, a banking system is insolvent because a banking system ends up, at its core, promising something it cannot deliver."

Mohamed El-Erian - PIMCO - "More than anything, the story of the last few years has been one of serial balance sheet contamination. Initially, private sector balance sheets were expanded well beyond sustainable levels, aided and abetted by financial innovation, the degradation of lending standards, and short-termism. Subsequently, too many balance sheets deleveraged simultaneously, threatening a global depression and forcing governments to step in with their own balance sheets to arrest an increasingly disorderly process.
        Last weekend’s drama in Europe is yet another illustration of this phenomenon. Policymakers are now forcefully using the balance sheets of the EU (ultimately Germany) and ECB to compensate for the debt excesses in the periphery (particularly Greece) and the related overexposure of European banks.
        As societies start to worry even more about public finances – and this is inevitable – it will become even more difficult to sequentially deploy new balance sheets in order to sustain the levels of debt and deficit that currently prevail… that is, unless there is yet another healthy balance sheet that can stealthily take on this debt for a while.
        Some argued during the Forum that central bank balance sheets could still be used for this purpose. This view was bolstered by the ECB’s recent response aimed at calming markets and safeguarding the euro. Others warned that markets and politicians (and voters, some of whom have already signaled their disdain) would consider this yet another form of inadvisable financial alchemy, thereby limiting the feasibility, desirability and effectiveness of this approach over the medium term.
        I am inclined to side with the second group in warning against the long-term implications of additional steps to turn monetary authorities (with revolving balance sheets) into fiscal agencies (with more permanent exposure to dubious assets). An even larger-scale use of central bank balance sheets, if it were to materialize, would provide only a temporary respite, and the collateral damage and unintended consequences would be serious, including the impact on inflationary expectations."

S. M. Ali Abbas, J. Bouhga-Hagbe, A. J. Fatas, P. Mauro, R. C. Velloso - Fiscal Policy and the Current Account - "This paper examines the relationship between fiscal policy and the current account, drawing on a larger country sample than in previous studies and using panel regressions, vector autoregressions, and an analysis of large fiscal and external adjustments. On average, a strengthening in the fiscal balance by 1 percentage point of GDP is associated with a current account improvement of 0.2–0.3 percentage point of GDP. This association is as strong in emerging and low-income countries as it is in advanced economies; and significantly higher when output is above potential."

Really great links - China - Libertarians for bailout - Dodd's financial reform bill - Gloom and doom

Michael Pettis - Beijing’s stop-and-go measures - "Real estate has also been affected. According to one report, after surging in early April, property prices in Beijing dropped a shocking 31% in the past month. I don’t know whether this is believable – I am always nervous about taking any of these numbers too seriously given the amount of manipulation that occurs – but clearly there is nervousness in the Beijing market"

Models & Agents - Greece - "Greece may be too small (and too wayward) to bail but it’s become systemic by association. And while the rescue of an idiot who put his house on fire may be against one’s libertarian philosophy, keeping the fire from spreading elsewhere is (as we’ve painfully come to learn) sound policy"

WSJ - C. Asness & A. Brown - Dodd's financial reform bill - "In the bill, a "swap" is defined as "any contract or transaction that has financial, economic or commercial consequence involving purchase, sale, payment or delivery with any contingent clause." We challenge lawmakers to think of any contract or transaction that doesn't meet that definition—from buying detergent with a money-back guarantee to getting a rain-check at the car wash. If you maintain a "substantial" net position in swaps, or if your failure to perform under your swaps could cause "significant" losses, you are considered a "major swap participant." And you really don't want to be one considering how you'll be regulated.
        "Substantial" and "significant" are never defined. The bill does not say whether they are to be measured relative to the global economy, or the financial positions of you and your counterparty, or for that matter to the average humidity of a mid-summer afternoon in Cleveland. All of this is to be named later."

John B. Judis - The Case for Economic Doom and Gloom - Dotcom bubble - "Paul Volcker summed up the situation thusly: “The fate of the world economy is now totally dependent on the growth of the U.S. economy, which is dependent on the stock market, whose growth is dependent upon about 50 stocks, half of which have never reported any earnings.”"

Really great links - Technical trading and crash - EU will fight bubbles - Naked CDS - David Friedman vs. Robert Frank

Rajiv Sethi - Technical trading strategies and Thursday's crash - "The best explanation that I have seen is contained in a message by an anonymous analyst that Yves Smith posted earlier today. The hypothesis is that the initial trigger came from algorithms implementing volume-sensitive technical strategies"

Ambrose Evans-Pritchard - EU - "Commission president Jose Barroso unveiled plans for EU control over national budgets, including an incendiary demand that Brussels should vet budgets before their first reading in Westminster, the Bundestag, and other parliaments. Current account deficits and credit growth will be monitored. Brussels can imposing sanctions on states that let booms run out of control. "We must get to the root of the problems," he said."

Brad DeLong - Naked CDS - "As far as naked CDS shorts are concerned, they make it easier for pessimistic noise traders and pessimistic fundamentals traders to affect prices. Optimistic noise traders and optimistic fundamentals traders can already affect prices--they go long CDSs, take on risk, and so lead to the construction of new houses."

David Friedman - My Response to Robert Frank's Reply - "I do not know if it has occurred to you, but one implication of your argument is that spending on schooling, insofar as it produces status, imposes a negative externality on others, so private individuals will tend to buy a more than optimal quantity of schooling for their children. It follows, on straightforward economic lines, that instead of subsidizing schooling, as we do on an enormous scale, we ought to tax it. If schooling is “inescapably relative,” we could cut every school’s expenditure in half and still produce the same amount of education, relatively speaking, while saving many billions of dollars. Perhaps that should be the subject of your next op-ed."

Really great links - Bailouts - Eurozone bailout - Finance as a source of economic regress

Tweet of the day - Garett Jones - "Bailouts: A transfer of wealth from firms that don't exist to firms that do exist."

Baseline Scenario - Eurozone bailout plan - "This is a whole new level of global moral hazard – the result of an alliance of convenience between troubled governments in the south of Europe and the north European banks (and implicitly, north American banks) who enabled their debt habit. The Europeans promise to unveil a mechanism this week that will “prevent abuse” by borrowing countries, but it is hard to see how this would really work in Europe today.
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        As Willem Buiter (formerly Bank of England, now at Citigroup) remarked last week, you have the greatest incentive to default when you are running a balanced primary budget (i.e., after substantial budget cuts) and still have a large government debt outstanding. His point is that the incentive structure of these programs means they will postpone a decision to default which would otherwise be rational now. "

Jean-Claude Trichet, President of the ECB - Finance as a source of instability and economic regress - "When – and how – can finance turn into a source of instability and economic regress? My answer is simple. When [...] screening and monitoring services are neglected, and when risk management, liquidity transformation and price discovery are flawed.
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        Paradoxically, securitisation – a new technique to control risk – had made risk control practically impossible"

Greece is Europe's Freddie Mac

Is Greece the new Argentina, the new Iceland, the new Lehman? No. Greece is Europe's Freddie Mac. Both are insolvent entities with a strong implicit guarantee. Both will require new regular subsidies needed to preserve the fiction of going concern. In 2008 one of the sources of PIMCO's outperformance was a bet on Freddie Mac's MBS. PIMCO has called that bet "shake hands with the government." Is it the time to shake hands with the government of Greece?

Really great links - Greece - Crash

Arvind Subramanian - Greece - Bailout programme - "Early satisfaction with the programme has given way to serious market doubts about it. These doubts are rational because the fiscal arithmetic simply does not work. For the IMF, this programme represents a squandered opportunity because it could have been ahead of events and designed a much better programme, specifically by facilitating orderly debt restructuring. Instead, we could end up with a programme that is inequitable, perverse and unsuccessful, with much greater costs all around.
        When the Greece saga began, the mantra of the German government and many purists in Europe, including the European Central Bank, was: “no default, no bail-out, no exit”. European private-sector holders of Greek debt would be spared any pain (no default). The European taxpayer would be protected (no bail-out). And European companies would be shielded because Greece could not devalue its currency (no exit). That left one and only one policy measure that could be brought to bear on the problem, namely a fiscal austerity programme, with the average Greek citizen bearing all the burden of adjustment. Europe, in short, had defined this to be an exclusively Greek problem."

Streetwise Professor - Crash - "NASDAQ has decided to cancel–bust–trades made between 2:40 and 3:00 PM ET if they were at prices more than 60 percent away from the market price prior to 2:40.
        Very bad idea.
        The orders executed at these prices were almost certainly stop orders. Old fashioned stop orders. The kind that have been destabilizing for years, not some newfangled HFT thing. When stops are hit, they reinforce the price movement that triggered them.
        Busting these trades therefore encourages the use of a particularly destabilizing type of order. If the idea is to reduce the amount of positive feedback in the system, this will have the exact opposite effect."

Really great links - Computer Trading - Tim Duy (Q1 GDP & Greece)

Streetwise Professor - Computer trading & crash - "This is the kind of automated trading that is problematic because it can create destabilizing positive feedback effects. Synthesizing index puts as portfolio insurance through a dynamic trading strategy means that big price declines triggered more sell orders that arguably exacerbated the price declines which caused additional sales, and so on. Option hedging strategies (e.g., dealers use dynamic hedges to manage the risk of options they’ve traded with customers) can have the same effect.
        Stop orders (which probably contributed to what transpired today) can have a similar effect; price declines (rises) trigger sell (buy) orders that can exacerbate price moves. These kinds of orders are as old as the market.
        Margin-driven trades can do the same: those suffering losses on a price decline (increase) sell (buy) and who cannot come up with the necessary margin sell (buy) to close positions–again, as old as the market.
        Some computerized trading–and I would argue that most algo trading–is very different. It is a negative feedback strategy. That’s what market makers do: they sell into purchases and buy into sales. Much algo trading is effectively automated market making. It is, in effect, the realization of what the great Fisher Black imagined in 1971, when he wrote an article in the Financial Analyst’s Journal titled “Towards a Fully Automated Stock Exchange.” Black envisioned a fully automated specialist that made markets, and thereby stabilized prices. Computerized/algo market making programs based on negative feedback would have bought on today’s decline as Black described. The rapid snap-back is perfectly consistent with that.
        Moral of the story: ignore categorical condemnations of computerized or quantitative trading in the aftermath of today’s events. There’s good, bad, and ugly. Be careful, and try to distinguish them."

Tim Duy - Still Unbalanced - GDP report - "The recent flow of data is interesting to say the least. While headline numbers are generally solid, the underlying story looks shaky. Shaky enough that disinflationary trends remain firmly entrenched in the US, whereas inflationary risks appear to be growing in emerging markets. The former suggests the Fed is set to remain on hold, while the latter will push foreign central banks to tighten. In a perfect world, that combination would put downward pressure on the Dollar and support a shift to a more balanced pattern of growth for both the world in general and the US in particular. Yet we persistently fall short of a perfect world. Will this time be any different? The Greek crisis is saying it won't.
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        The Greek crisis. The Greek drama is obviously far from over; it is not clear that the threat of contagion is even significantly reduced, let alone eliminated. Nor would it be until all the PIIGS committed to a growth sapping fiscal stance, which the Greek public are finding hard to accept. That stance, while perhaps necessary, weighs against global growth and tends to strengthen the Dollar, slowing the rebalancing process. Moreover, I find it difficult if not impossible to believe that the impacted nations can adjust without a significant devaluation. Which suggests the Euro has further to fall. But it is reasonable to believe that, given the German weight in the Eurozone, any decline in the Euro would fall short of what is necessary for the PIIGS to fully adjust. Are we really down to just two choice then? Either Northern Europe commits to perpetual fiscal transfers to Southern Europe (not going to happen), or the Eurozone shrinks? Both suggest a weaker Euro, but the latter points to an outright collapse."

Really great links - Saving the Eurozone - Bank of England - Moral hazard in ant colonies

Baseline Scenario - To Save The Eurozone - "The liquidity support involved would be large: if we assume that roughly three years of sovereign debt repayments should be fully backed – and it takes that kind of commitment to break such negative sentiment – then approximately $1 trillion would be needed to backstop Greece, Portugal, Spain and Italy. It may be that more funds are eventually needed – but in any case, the amounts would be less than the total reserves of China. These amounts would also be reduced as the euro falls; it could be heading back to well under $1 per euro, which is where it stood one decade ago."

Chris Giles - Bank of England forecasting errors - "The Bank’s forecasting failure has left real output 12 per cent lower than the Bank thought it would be in late 2007, although the Bank thinks the level of GDP will be revised higher by 1.5 per cent from where it is now, making the true difference in the forecasts (a mere) 10.5 per cent.
        With such a large fall in output relative to expectations, the normal consequence would be an undershoot of inflation. But the British price level is also 2 per cent higher now than the Bank thought it would be in November 2007. Oh dear.
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        But it now pretty certain that the level of GDP consistent with stable inflation is much lower than we thought before the crisis, and there has to be a fear that the sustainable rate of growth consistent with stable inflation has fallen, as it did in Japan after its crash in 1990. As Charles Goodhart, former chief economist of the Bank, said: “nobody knows what the sustainable rate [of growth] is and they adjust it relatively slowly to the actual rate. And that’s not particularly encouraging”"

Cheap Talk - Are Ant Colonies more Rational than Humans: Lessons for Organization Theory? - "In other work, Pratt shows that ant colonies obey transitivity (i.e. if a colony prefers A to B and B to C, it prefers A to C).
        Why are ant colonies more rational than individual humans? The authors offer a cool hypothesis: choice between colonies is typically made by sending independent scouts sent to the different options. No scout visits different locations. The scouts reports are simply compared and the best option is chosen. A human being contemplates all the choices by herself and has a harder time comparing the attributes independently leading to a violation of IIA.
        An ant colony is like a well performing and coordinated decentralized firm with employees passing information up the hierarchy and efficient decisions coming down from the center Can we import lessons into designing firms? Alas, I believe not. A human scout evaluating a decision/option will not be as impartial an ant scout. He will exagerrate its qualities, hoping his option “wins”. He hopes to get the credit for finding the implemented option, get promoted, receive stock options and retire young to the Bay Area. In other words, career concerns ruin a simple transfer of ant colony principles to firms. If we eliminate career concerns within the firm, we will induce moral hazard as there is no incentive to exert costly effort to find the best decisions for the firm. Ants in the same colony do not face the same issue as they are genetically related and have “common values”."

Really great links - Bailout chart - Krugman on Greece I & II - Global financial assets - Fiscal adjustment

Zero Hedge - Greek bailout chart - "Ignore for a second the sheer lunacy of anyone who thinks that the Greek government can grow GDP and decline the budget deficit in a straight line now that the country will see crippling strikes and rolling riots (not to mention blackouts) on a daily basis. But do note the black line, which shows the projected Debt/GDP ratio for the country as part of the bailout package. In essence Greece will go from having "only" a 133% Debt/GDP ratio to an insane 149% in 2013 before presumably dropping to 144% lower in 2014, still a good 11% higher than currently. Greece just got bailed out so it can get into even more debt!"

Paul Krugman - Greek bailout - "The EU has now, in effect, given up on trying to restore market confidence; instead, it’s going to break the death spiral by main force, providing Greece with all or almost all the financing it needs directly, at an interest rate much lower than the market was demanding.
        The plan still requires savage austerity on Greece’s part, and ensures a terrible few years for the Greek economy. But it does rise to the scale of the problem, and it might work."

Paul Krugman - How Reversible Is The Euro? - "For a long time my view on the euro has been that it may well have been a mistake, but that bygones were bygones — it could not be undone. I was strongly influenced by the view expressed by Barry Eichengreen in a classic 2007 article (although I had heard that argument — maybe from Barry? — long before that piece was published): as Eichengreen argued, any move to leave the euro would require time and preparation, and during the transition period there would be devastating bank runs. So the idea of a euro breakup was a non-starter.
        But now I’m reconsidering, for a simple reason: the Eichengreen argument is a reason not to plan on leaving the euro — but what if the bank runs and financial crisis happen anyway? In that case the marginal cost of leaving falls dramatically, and in fact the decision may effectively be taken out of policymakers’ hands."

Brad DeLong - Global financial assets - PowerPoint link - "

•$80 trillion of global financial assets three years ago.

•$60 trillion of global financial assets today.

•Default, duration, risk, and information discounts.

•Default discounts:

–A $3 trillion increase from mortgages.

–A $6 trillion increase from other forecast recession losses.

•Duration discounts:

–A -$4 trillion move by central banks.

–What monetarist theories said you should do.

•Risk and information:

–A +$15 trillion increase in the discount on low-quality financial assets

•That is a gauge of the magnitude of the imbalance in the market for high-quality investment assets"


Alcidi Cinzia, Daniel Gros - The European experience with large fiscal adjustments - "Fiscal adjustments of the size now required by Greece (and probably soon Portugal and Spain) have been possible in the past.
Adjustments of this size require time, typically at least 5 years; and the debt to GDP ratio keeps on increasing during the adjustment process."