Breaking Up Is Hard To Do II

by Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Conversations about the breakup of the Eurozone are changing as the debate about a break up continues to evolve.   Some analysts (including the author) argue that ’avoid breakup at all costs' dogmatism may not be a prudent view. Getting good data may well be difficult, but any arguments about the cost of a Eurozone breakup must be compared to the ongoing cost of the status quo.

Jens Nordvig looks at this issue in a recent VOXEU communique (6th Nov.) called The Eurozone breakup debate: Uncertainty still reigns. In the spring of 2012, political tension in Greece was the debate focus while in the summer the focus shifted to Spain’s funding difficulties, especially the redenomination risk on Spanish assets. Then the ECB stepped in and reduced sovereign funding costs in the periphery. Subsequently, the Eurozone breakup debate has again shifted focus to core countries.

There is limited consensus on the implications of various forms of breakup and on the preferred path for the Eurozone. European policymakers remain adamant that the Euro is irrevocable. Meanwhile, academic economists and market strategists continue to disagree about both the merits of keeping the Eurozone together and about the costs of any breakup scenario.

Despite years of debate, little progress towards reaching an informed consensus has been achieved. While, the question remains on what can be done to more objectively evaluate the implications of various breakup scenarios?

The Eurozone remains unique as a currency union: (1.) The Eurozone is large in economic terms and differs from past currency unions that have split. (2.)  Eurozone countries are substantially wealthier than other countries that have experienced a breakup in the past. (3.) The euro serves a unique role both as a reserve asset and as a currency widely used in international capital markets.

The effects from a Eurozone breakup on macro-level balance sheets will be determined by the relevant external assets and liabilities that are defined as those cross-border positions where the legal jurisdiction of underlying financial contracts is foreign to the country in question.  Basic macroeconomic datasets - such as net foreign asset positions and cross-border banking statistics - are really useful if we wish to analyze the implications of currency union breakups. Yet current official data sources tell us nothing about the legal jurisdiction of the assets and liabilities in question.  The author estimates the euro’s international dimensions of €20 trillion of euro-denominated contracts in existence outside the jurisdiction of individual Eurozone countries, not a minor issue.

The breakup scenarios being debated, involving strong countries exiting, also change the analysis. Problems associated with extreme capital flight that have been used to argue that the cost of a breakup would be prohibitively costly, would be smaller in a situation where a strong country leaves. For instance, a Finnish exit could be managed without devastating disruption to financial markets. Thus, 'avoid breakup by all means' is not a universal truth.

The costs of the status quo need to be considered; how much would non-breakup cost? The cost of the current policy path is not explicitly accounted for. Quantifying the cost of the status quo is a dynamic exercise and most would agree could be more costly than was predicted earlier.  A robust cost-benefit analysis is needed that includes specific Eurozone breakup scenarios versus the costs of the current path of gradual integration. Many different Eurozone breakup scenarios have been debated but without being able to properly quantify the effects of breakup scenarios, uncertainty still reigns.

www.voxeu.org/article/ez-breakup-contest-take-ignorance

Breaking Up Is Hard To Do II

by Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Conversations about the breakup of the Eurozone are changing as the debate about a break up continues to evolve.   Some analysts (including the author) argue that ’avoid breakup at all costs' dogmatism may not be a prudent view. Getting good data may well be difficult, but any arguments about the cost of a Eurozone breakup must be compared to the ongoing cost of the status quo.

Jens Nordvig looks at this issue in a recent VOXEU communique (6th Nov.) called The Eurozone breakup debate: Uncertainty still reigns. In the spring of 2012, political tension in Greece was the debate focus while in the summer the focus shifted to Spain’s funding difficulties, especially the redenomination risk on Spanish assets. Then the ECB stepped in and reduced sovereign funding costs in the periphery. Subsequently, the Eurozone breakup debate has again shifted focus to core countries.

There is limited consensus on the implications of various forms of breakup and on the preferred path for the Eurozone. European policymakers remain adamant that the Euro is irrevocable. Meanwhile, academic economists and market strategists continue to disagree about both the merits of keeping the Eurozone together and about the costs of any breakup scenario.

Despite years of debate, little progress towards reaching an informed consensus has been achieved. While, the question remains on what can be done to more objectively evaluate the implications of various breakup scenarios?

The Eurozone remains unique as a currency union: (1.) The Eurozone is large in economic terms and differs from past currency unions that have split. (2.)  Eurozone countries are substantially wealthier than other countries that have experienced a breakup in the past. (3.) The euro serves a unique role both as a reserve asset and as a currency widely used in international capital markets.

The effects from a Eurozone breakup on macro-level balance sheets will be determined by the relevant external assets and liabilities that are defined as those cross-border positions where the legal jurisdiction of underlying financial contracts is foreign to the country in question.  Basic macroeconomic datasets - such as net foreign asset positions and cross-border banking statistics - are really useful if we wish to analyze the implications of currency union breakups. Yet current official data sources tell us nothing about the legal jurisdiction of the assets and liabilities in question.  The author estimates the euro’s international dimensions of €20 trillion of euro-denominated contracts in existence outside the jurisdiction of individual Eurozone countries, not a minor issue.

The breakup scenarios being debated, involving strong countries exiting, also change the analysis. Problems associated with extreme capital flight that have been used to argue that the cost of a breakup would be prohibitively costly, would be smaller in a situation where a strong country leaves. For instance, a Finnish exit could be managed without devastating disruption to financial markets. Thus, 'avoid breakup by all means' is not a universal truth.

The costs of the status quo need to be considered; how much would non-breakup cost? The cost of the current policy path is not explicitly accounted for. Quantifying the cost of the status quo is a dynamic exercise and most would agree could be more costly than was predicted earlier.  A robust cost-benefit analysis is needed that includes specific Eurozone breakup scenarios versus the costs of the current path of gradual integration. Many different Eurozone breakup scenarios have been debated but without being able to properly quantify the effects of breakup scenarios, uncertainty still reigns.

www.voxeu.org/article/ez-breakup-contest-take-ignorance

Policy, Risk & Future of the International Banking System

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The international banking industry faces a challenging future, having to consolidate at a time of heightened global financial volatility, anemic growth in advanced countries, and shifting global growth balances. After a long period of sustained expansion and accommodating regulatory treatment, the structure of   international banking is changing as global banks’ business strategies shift toward fast-growing emerging-market economies. 

The center of gravity for international lending is shifting, with the role of European banks shrinking and American, Japanese, and emerging-market banks filling in the space.  These issues were raised in a recent World Bank Economic Premise called What Does the Future Hold for the International Banking System  by Mansoor Dailami and Jonathon Adams-Kane (October 2012).

As the international banking community goes through a long-period of soul-searching and introspection in an effort to understand the causes and consequences of the 2008 global financial crisis, in which international banks were at the epicenter, looking ahead to anticipate the configuration of the international banking system would help to formulate regulatory reforms to strengthen the banking sector itself, but also to inform the current debate on international macroeconomic policy. The forward-looking analysis contains a policy warning regarding the current mix of fiscal and monetary policy stances in the context of ongoing deleveraging by banks. By now there is a fair degree of consensus that progress in fiscal consolidation in advanced economies is likely to be slow, painful, and charged with political tensions as austerity kicks in.

Against this backdrop, the current debate on adding economic stimulus to support the global economic recovery should consider the possible contractionary impacts of bank deleveraging, even with global interest rates remaining at historically low levels.  The timing of the deleveraging cycle currently underway is poor in terms of its impact on near-term global economic conditions.  Deleveraging among banks is reinforcing the contractionary economic environment already at work in the form of tight government budgets.

At the same time, there is a limit to how much monetary policy can be relied upon to simultaneously provide macroeconomic stimulus and address the specific needs of sovereign and banking finance, especially given the ways central banks have intervened to stabilize financial markets . The important implication that emerges from the current policies and public debt profiles is that the banking sector may bear a significant part of the burden of elevated sovereign debt distress. For euro area banks affected by sovereign debt distress, the most visible sign is deteriorating funding market conditions, significant credit rating downgrades, and a decline in market capitalization. Indeed, given the significant international presence of European banks and their role in global interbank markets, the potential for spillover of the negative feedback loop among public finances, the financial sector, and the real economy currently underway in the euro area should be of concern to the broader international policy community and risk managers.

www.siteresources.worldbank.org/EXTPREMNET/Resources/EP94.pdf

Complexity, Economics & Risk

by Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The economic crisis has thrown the inadequacies of macroeconomics into focus. This has led to the argument that the narrow conception of the macroeconomy as a system in equilibrium is problematic. Economists should abandon entrenched theories and understand the macroeconomy as a self-organizing complex system.

This is a question asked by Alan Kirman in a recent VOXEU communique (29^th Oct.)  called What is the use of economics? The author offers detailed suggestions on what alternative ideas economists can teach their future students that better reflect empirical evidence of financial markets.

The question was raised during a recent conference as to what extent has - or should - the teaching of economics be modified due to the current economic crisis? For macroeconomists, the reaction has been to suggest that modifications of existing models to take account of ‘frictions’ or ‘imperfections’ will be enough to account for the current evolution of the world economy.

However, some economists feel that we have finally reached the turning point in economics where we have to radically change the way we conceive of and model the economy and risks. The crisis is an opportunity to carefully investigate new approaches. Economists tend to inaccurately portray their work as a steady improvement of their models whereas; empirical reality is changing just as fast as their modeling. The economist’s instinct is to attempt to modify reality in order to fit a model that has been built on longstanding theory. Unfortunately, that very theory is itself based on shaky foundations.

Economics is faced with the model of the isolated optimizing individual who makes his choices within the constraints imposed by the market. Somehow, the axioms of rationality imposed on this individual are not convincing. There is equilibrium with prices that will clear all markets simultaneously and has desirable welfare properties.  Students are taught that the aggregate economy or market behaves just like the average individual they studied, but are not told that these general models perform poorly.

Macroeconomists are faced with a stark choice: either move away from the idea that we can pursue our macroeconomic analysis whilst only making assumptions about isolated individuals, ignoring interaction; or avoid all the fundamental problems by assuming that the economy is always in equilibrium, forgetting about how it ever got there.

The author suggests three ways to improve economic education: (1.) spend more time insisting on the importance of coordination as the main problem of modern economies rather than efficiency. (2.) cease to insist on the idea that the aggregation of the choices and actions of individuals who directly interact with each other can be captured by the idea of the aggregate acting as only one of these many individuals.  (3.) recognize that some of the characteristics of aggregates are caused by aggregation itself.

Does this mean that we should cease to teach ‘standard’ economic theory? For the moment, standard economics is what economists do. However, we need to point out difficulties with the structure and assumptions of our theory. Although we are still far from a paradigm shift, in the longer run the paradigm will inevitably change. We need to remember that current economic thought will one day be taught as history of economic thought.  Until we fully understand how the macroeconomy works as a complex adaptive system, risk analysis will remain a problem.

www.voxeu.org/article/what-s-use-economics