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

Not making the grade: Report on global financial reform

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

While financial reform is underway around the world, this communique argues that more needs to be done.  The reform agenda aims to make the financial system safer while allowing it to provide the intermediation services needed to promote stable economic growth. The intentions of policymakers are clear with a host of reforms in the right direction. The system, however, remains vulnerable; the pre-crisis financial structures have not changed much, and they will need to change.

Laura Kodres, of the IMF, in a recent VOXEU communique Not making the grade: Report card on global financial reform (15^th Oct.) discussed these issues.  Progress was defined by:  (1.) Compared to the pre-crisis period, the financial system should be more transparent with better governance. (2.) Both regulators and investors should be able to understand the location of risks, and be able to price them properly. (3.) The system should have less leverage and be made less prone to booms and busts.

This can be accomplished with stronger financial institutions that are better equipped to withstand the distress of downturns by holding more loss-absorbing capital and higher liquidity buffers.  The reformed system should allow risks to be diversified – reaping the benefits of interconnectedness and globalization, but without the risk of contagion. Resolution of unviable financial institutions should occur in a timely manner and minimum cost.

 The research on reforms focuses on the features of financial systems related to the crisis that need to be addressed to achieve the goal of a stable and effective system.  These include: 1) large, dominant, and highly interconnected institutions 2) the heavy role of non-banks, and 3) the development of, for instance, complex financial products.

While the results should be interpreted as very preliminary, the results are in line with the priors. Progress on Basel capital rules are driving banks to alter their liability structures to economize on regulatory costs.  Progress is also muting the severe drop in securitization – a result tied closely to the fact that the countries that have made the most progress on Basel 2 and 2.5 are in Europe, where securitization is being used to produce postable collateral at the ECB.  

The reforms are moving the structures in the right direction, but progress is slow. Some regions are still in a crisis.  There are built-in, long implementations for the agreed reform agenda.  However, the basic financial structures that are problematic before the crisis are still present: (1.) financial systems are still overly complex. (2.) Banking assets are highly concentrated, with strong domestic interlinkages. (3.) The too-important-to-fail issues are unresolved. (4.) Banking systems are still over-reliant on wholesale funding.

Going forward, the following issues need to be addressed: (1.) more discussion on what it takes to break the 'too-important-to-fail' conundrum, including a global level discussion of the pros and cons of direct restrictions on business models. (2.) We need further progress on recovery and resolution planning for large institutions, especially cross-border resolution. (3.) Better monitoring and, if needed, a set of prudential standards for nonbank financial institutions posing systemic risks within the so-called shadow-banking sector. (4.) Careful thought about how to encourage simpler financial products and simpler organizational structures.

Even with new rules on the books, their success depends on enhanced supervision, the political will to implement regulations, incentives for the private sector to adhere to the reforms, and the resources necessary for the task of making the financial system simpler and safer. Policymakers need to press ahead at a faster pace to avoid another accident.

www.voxeu.org/article/not-making-grade-report-card

US Economic Recovery and Risk of Policy Gridlock

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

The US recovery is painfully slow and monetary policy is at its limits in a balance sheet recession. Pervasive economic uncertainty appears to be holding the US back in terms of lost output and job creation. But what is the root cause of this uncertainty?

This is what Nicholas Bloom, Scott Baker, Steven J. Davis, John Van Reenen attempt to answer in a VOXEU communique dated Oct. 29^th called  Economic recovery and policy uncertainty in the US . The authors argue that a polarized political system is to blame. Without a political mechanism that incentivizes the election of moderate politicians, the authors predict further political divergence between Republicans and Democrats and a consequent intensification of policy uncertainty.

There are several potential causes of slow recovery:  (1.) one explanation attributes low demand to the financial crisis and the consequent dislocation of capital markets.   Although monetary policy has been aggressive, it has reached its limits as quantitative easing has hit a point of diminishing returns. (2.) An additional explanation in this demand-shock story is an increase in uncertainty. Uncertainty can retard both investment and hiring as firms become reluctant to make costly decisions.

Greater uncertainty increases risk premiums in financial markets which in turn raises the cost of borrowing for firms and households.  Previous research has identified additional mechanisms whereby uncertainty undermines macroeconomic performance. The authors find that high levels of policy uncertainty foreshadow lower levels of output, investment, and employment.  In recent months, uncertainty about the US election and the ‘fiscal cliff’ has contributed to a recurrence of policy uncertainty.

The authors try to separate the effect of policy uncertainty from other factors, such as low demand and estimate that the increase in policy uncertainty after 2007 reduced employment by 2.3 million.

The authors blame high levels of policy uncertainty with both political parties. However, politicians see it otherwise: Republicans are blaming the President and Democrats for creating regulatory uncertainty, and failing to face up to the main long-term social programs causing rising debt. Democrats accuse Republicans of obstructionism on tax and spending cuts while not providing meaningful details on their healthcare reform proposals and fiscal programs.

This move to the extremes can be partly explained by the ability of incumbents to gerrymander political districts, that is, to change Congressional district boundaries along partisan lines in order to maximize an incumbent’s chances of re-election. Gerrymandering, in turn, encourages primary election campaigns that focus on appealing to extreme political bases rather than moderate voters.

It is unclear whether the November elections will significantly alleviate US policy uncertainty.  A clear victory for one party could greatly clarify the policy outlook, but that outcome appears unlikely based on polling data.  Regardless of who wins the presidency, the two houses of Congress are likely to remain divided by party.  Thus, the increasing political polarization of the last 30 years is also very likely to continue.  Until the advent of a political mechanism that creates incentives to elect moderate representatives who can reach across the ideological divide, it seems the US is destined to entrench high levels of policy uncertainty with below trend output growth and job creation.

www.voxeu.org/article/economic-recovery-and-policy

Policy uncertainty website:  www.policyuncertainty.com

Uncertainty and the Global Recovery

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

Bouts of elevated uncertainty are defining features of the sluggish global recovery from the financial crisis.    A number of analysts suggest a link between the high level of uncertainty and the weak recovery.  Uncertainty is associated with escalating financial stress in the Eurozone, stalling US labor markets, and slowing growth elsewhere.  The authors ask two questions: how has uncertainty evolved and how does it affect growth and business cycles?  This is asked by Kose and Terrones is a recent VOXEU communique Uncertainty Weighing on the Global Recovery. 

Economic uncertainty refers to an environment in which little or nothing is known about the future.  There is a great variety of sources of economic uncertainty, including changes in economic and financial policies, dispersion in future growth prospects, productivity movements, political events, and natural disasters 

The authors consider four measures of uncertainty: (1) the standard deviation of daily stock returns, (2) an indicator of the implied equity volatility, (3) an uncertainty index of economic policies; and (4) a global uncertainty index.  Both macroeconomic and policy measures of uncertainty rise during global recessions.

Policy uncertainty in the US and the Eurozone has remained high since the global financial crisis and the recent sovereign-debt problems. Moreover, during the lethargic global recovery, uncertainty has been unusually high and volatile in contrast to other global recessions, which were accompanied by steady declines in uncertainty.  Uncertainty is highly countercyclical at a national level while macroeconomic uncertainty varies over the business cycle.

Economic theory suggests that macroeconomic uncertainty can have an adverse impact on output through a variety of channels.  The authors find the growth rate of output is negatively correlated with macroeconomic uncertainty.  Policy-induced uncertainty is also negatively associated with growth.  The recent increase in policy uncertainty may have stunted growth in advanced economies by 2.5%. The degree of economic uncertainty appears related to the depth of recessions and strength of recoveries.  In particular, recessions accompanied by high uncertainty are often deeper than other recessions. Similarly, recoveries coinciding with periods of elevated uncertainty are weaker than other recoveries.   

Elevated uncertainty historically coincides with periods of lower growth, and the recent pickup in uncertainty raises the specter of another global recession. Policymakers can do little to alleviate the intrinsic uncertainty economies typically face over the business cycle.  However, policy uncertainty is unusually high, and it contributes significantly to macroeconomic uncertainty.  By implementing bold and timely measures, policymakers can reduce policy-induced uncertainty and help kick-start economic growth.

www.voxeu.org/article/uncertainty-weighing-global-recovery