Friday, 24 October 2008


The Global Financial Crisis: Will Hutton and Martin Wolf in conversation with Professor David HeldDate: Monday 20 October 2008Time: 6.30-8pmVenue: Old Theatre, Old BuildingSpeakers: Will Hutton, Martin WolfChair: Professor David Held
Videocast available above, also available as a podcast: see Public Lectures and Events: podcasts


por Vanessa Jurgenfeld | De São Paulo
Professor da Universidade de Cambridge, Ha-Joon Chang aponta lições da Coreia do Sul para a economia brasileira

Bretton Woods II, with caveats
I broadly agree with Jeffrey Sachs' proposals, but there are flaws in his ideas for trade reform and his development strategies
Ha-Joon Chang -, Wednesday October 22 2008 16.00 BST Article history
In setting out his agenda for Bretton Woods II, Professor Jeffrey Sachs has gone far. He proposes a Tobin tax – a tax that has been a bete noire of the international financial industry and hence the rich country's, especially US, governments. His rejection of emission trading in favour of a straightforward carbon tax is also bold – and in my view correct.
There are many things, however, that he could have added in relation to the reform of the international financial system. For example, he could have proposed the introduction of a country bankruptcy code that will enable orderly sovereign debt restructuring. He could have talked not only of expanding the capital adequacy requirement, but also making it counter-cyclical, rather than pro-cyclical as it currently is. More strict regulations of tax havens and private equity funds, which have greatly contributed to increasing opacity in the financial market, should also have been mentioned. He could also have talked about the credit rating agencies. In light of the critical role they play in today's financial system and the damages they have inflicted by blessing all those toxic assets, these agencies need to be much more heavily regulated or even replaced by an international public body. All of these would have been compatible with his overall approach, so the differences between us in this regard are a matter of emphasis rather than of principles.
However, I have some disagreements with Sachs's vision of how to reform the IMF, the World Bank, and the world trading system.
As for Sachs's proposal to turn the IMF into a proper lender-of-last-resort, I fear that a vastly strengthened IMF without a serious reform of its missions and its governance structure is likely to make things even worse. The IMF has caused great damage to developing (and former socialist) economies that have come under its tutelage by insisting on deflationary macroeconomic policies and premature financial de-regulation and opening up. Without abandoning these policies, an expanded IMF will be even more capable of inflicting damages on its client countries.
Of course, the IMF has been able to continue with these problematic policies because the suffering countries do not have much say in the running of the organisation. Therefore, the voting shares in the IMF (and in the World Bank) need to be re-distributed in favour of developing countries. This is partly to reflect the dramatic changes in international economic power balances since its foundation, but more importantly to increase the voice of the "customers" (mostly developing countries), when there is no competitor to whom dissatisfied customers can turn.
I am also not persuaded by Sachs's development strategy. I am all in favour of achieving the millennium development goals as soon as possible, but, unlike what its middle name suggests, the MDG is mainly about providing basic needs (health, education, and poverty reduction) and little about development in the true sense of the world – expansion and upgrading a country's productive capabilities. True, making individuals more productive through better health and education will increase a country's productive capabilities, but there is only so much that can be achieved through individual improvements. A lot of productive capabilities in modern economies need to be accumulated in the form of organisational routines and institutional memories in (public, private, and cooperative) productive enterprises through actual production experiences. To put it graphically, what really distinguish the US or Germany, on the one hand, and the Philippines or Nigeria, on the other hand, are their Boeings and Volkswagens, and not their economists or medical doctors. The achievement of the MDGs is a noble goal in itself, but it is not the same as development.
Even more problematic is Sachs's support for "aid for trade" deal. In this deal, developing countries are asked to liberalise their trade in order to get the additional foreign aid that will enable them to make extra investment in skills and infrastructure. However, trade liberalisation will destroy, and make it very difficult to newly set up in the future, the very locales of accumulation of productive capabilities, namely, productive enterprises in high-productivity industries. This is why all of today's rich countries – starting from 18th century Britain and 19th century US and Germany, down to late 20th century South Korea and Taiwan – did not first invest in education and skills in general and then developed new industries. They first set up new enterprises with the help of (intelligently used, of course) protectionism and subsidies and then went on to invest in skills and technologies that those industries needed, as I document in my book, Bad Samaritans. Asking the developing countries to give up those policy tools is telling them to give up development.
We need a more wide-ranging and more productivity-oriented approach than Sachs's, if we want to make the global system more productive, durable, and equitable.

Amid the rubble of global finance, a blueprint for Bretton Woods II
A one-off summit limited to market regulation will not cut it. Durable reform must also tackle climate change and world poverty
Jeffrey Sachs - The Guardian, Tuesday October 21 2008 Article history

The international financial system is broken. An integrated set of reforms will be needed to achieve sustained economic growth and shared prosperity. The G8 leaders of Europe, Japan and the US have agreed on an emergency summit this autumn in New York to revamp the international system - a good idea, provided it initiates a wide-ranging set of changes rather than being a one-off meeting focused on market regulation.
The G8 leaders are keen to start on regulation and that is understandable. Wall Street, the City of London and other financial centres ran wild with undercapitalised borrowing and lending stoked by over-the-top fees and bonuses. Alan Greenspan's Federal Reserve fed the financial bubble with rock-bottom interest rates and regulatory forbearance, when it had the chance to restrain it. And the derivatives market was allowed to become so vast and unwieldy that there is no clarity as to who owes what to whom in tens of trillions of dollars of credit default swaps and other derivatives.
Risk assessments have been made enterprise by enterprise without consideration of systemic risk. When institutions are "too big to fail", they must be closely supervised so that indeed they don't bring the entire system down when they do, from time to time, fail. And we have learned again that there is no global lender of last resort, only a hodgepodge of individual central banks and treasuries, whose individual actions may be sufficient or not to stem a panic.
The G8 leaders must go well beyond the issues of financial regulation, however. Even before the current crisis, the global economic system was failing in crucial ways. Many poor countries remain cut off from global prosperity, often falling into poverty-induced violence and conflict. These will be still harder hit by the downturn. The global environmental crisis was also worsening, and climate shocks were wreaking havoc with world food supplies. Energy systems were in turmoil as the growing world economy pushed against supply constraints, yet there was no consensus on how to create an energy system compatible with the environmental and economic needs of the planet. These challenges are in desperate need of attention not only on their own merits, but also because global economic growth cannot be sustained without solutions to these crises.
Financial assistance to the poorest countries - a lifeline for more than a billion people - is in tatters. Europe and the US have mobilised around $3 trillion in the past month in guarantees and bail-out funds for the banks but failed to mobilise even one ten-thousandth of that this year to help the world's poorest grow more food in the midst of a massive food-price increase and hunger crisis.
The US has been blind to the millennium development goals (MDGs) on fighting poverty, hunger, and disease. When George Bush addressed the UN in September - supposedly the mid-point in achieving the goals - he mentioned "terror" 31 times while failing to mention the goals even once. All the big donors except Britain - including the US, Japan, France, Germany, Italy, and Canada - are failing to live up to long-standing aid commitments.
The leaders should pause to reflect that there is another little-mentioned international summit scheduled for December in Doha, Qatar, to take up the challenge of financing development. It comes six years after a similar summit in Mexico, at which countries pledged "concrete efforts" to achieve 0.7% of GNP in development assistance - a level of aid none of them have yet fulfilled.
A true Bretton Woods II summit would set a financial framework to achieve urgent global goals in macroeconomic stability, economic development, environmental sustainability and trade for development. All these are vital for long-term sustainable growth, but global goals in all four areas remain unachieved. Summiteers should come with chequebooks and international commitments in hand.
Here, then, is an agenda for Bretton Woods II. First, we need to restructure global finance, based on an expanded system of capital adequacy standards, financial reporting, system-wide risk management, and new lender-of-last-resort capacities. Derivatives traders, hedge funds, and broker dealers would be brought under regulatory control. The IMF would be empowered to be a true global lender of last resort (as I urged a dozen years ago, warning of the threat of self-fulfilling panics). To make this possible, a small tax on financial transactions - a Tobin tax - would be implemented to expand the IMF's war chest in case of crisis and to fund other urgent international needs.
Second, the new global financial structure should help to rescue the world from human-induced climate change. A straightforward tax on the carbon content of fossil fuels, levied by all countries, would do the job, and much better than the enormously cumbersome emission-trading system concocted and championed by the same financial engineers who brought us our current banking crisis. Most of the carbon-tax revenues would stay at home in each country, to help finance low-emission technologies. Some would be directed to finance three global public goods: research and development on sustainable energy; transfer of sustainable-energy technology to low-income countries; and climate-change adaptation.
Third, the World Bank should be refocused with clear goals, and accountability for their success. Specifically, the bank should have one overarching assignment: helping the poorest countries achieve the millennium development goals to reduce poverty, hunger and disease. The bank is poorly organised for such leadership today. Like any bureaucracy, it avoids being held accountable for measurable results. With a tighter focus on the MDGs, the bank should also be supported with much larger financial resources from new revenue sources (such as the Tobin tax), so that the bank can better help the poorest countries expand vital infrastructure (power, roads, water, sanitation and broadband networks).
Fourth, the global trade agenda should be integrated with the finance, and environment objectives. The Doha trade round has failed because the world could not see any urgent reasons for its success. A trade agreement worthy of the effort would do two main things. Importantly, it would help the poorest countries to be more productive so that they can be full participants in the global trading system. "Aid for trade" would help these countries to build the skills, roads, bridges and clean power grids to support increased trade. In addition, global trade would promote environmental sustainability, to help enforce compliance with reduced carbon emissions and protection of endangered biodiversity.
All these reforms are vital for long-term sustainable growth and development. If the political leaders focus only on financial-sector stability, but neglect the long-term problems of energy supplies, climate change, food production, disease control and extreme poverty, then global growth might be restored in the short term, only to succumb quickly to another global bout of rising energy and food prices, and geopolitical instability.
The shortcomings of the existing Bretton Woods institutions, global environmental policies and international trading arrangements have been widely recognised for at least a generation. The current global crisis, and arrival of a new US president in the midst of this unprecedented economic meltdown, may finally mark the moment when the world takes seriously the urgent global economic and environmental agenda that confronts us in this new millennium. A summit in December will be a small step but could be the first meaningful action to steer the world to safety from the dire threats we face.
• Jeffrey Sachs is director of the Earth Institute at Columbia University and author of Common Wealth

Tuesday, December 9, 2008
Questioning the Commodities Super Cycle
Conventional wisdom is that the plunge in commodities was due in part to the deflating of a speculative bubble, the balance the result of the nasty contraction now in full force. Once things recover, basic materials should enjoy a strong rebound as China and other emerging markets get back on the growth path. Comparisons to the Great Depression are also encouraging, since commodities rallied before stocks did.But the optimistic case is not as clear cut as it sounds. Oil bulls point to the unusually steep contango, where futures prices are markedly higher than spot (backwardization is the more normal state of affairs). Traders can now reap attractive risk free profit by buying crude, storing it, and selling it forward. And when was the last time the contango was this steep? In 1998, when the price of crude fell to under $10. Historically, a contango this steep is consistent with a glut. And while oil prices did increase from the 1998 bottom, they had reached just under $12 by year end and $16.50 by year end 1999. That may sound like an impressive recovery, until you consider that oil had been nearly $29 at year end 1984, $23 at the close of 1990, and over $18 at year end 1997 (which was lower than 1996). That is a long-winded way of saying a sharp recovery from the bottom (which some are now saying could be as low as $25) does not appear likely.An article in today's Financial Times keys off the downbeat oil demand forecasts from the World Bank and the US Energy Department. First, from the FT piece on the two studies, "Global demand for oil to plummet":
Global oil demand will collapse next year and commodities will not return to the highs they reached this summer in the foreseeable future, two authoritative reports said on Tuesday as they forecast a long and painful worldwide recession....The US energy department said global oil demand will fall this year and next, marking the first two consecutive years’ decline in 30 years....Meanwhile, the World Bank’s Global Economic Prospects report said the commodities boom of the past five years – which drove up prices 130 per cent – had “come to an end”.The World Bank’s analysis of the commodities boom contrasts with the prevalent view among natural resources companies – and most Wall Street analysts – that the ongoing price drop is a correction within an upward trend....Oil would return to about $75 a barrel within the next three years, it said, while food would trade 60 per cent higher than in 2003, but about half below this year’s record.“Over the longer run, the price of extracted commodities should fall,” the bank said, adding that because of slower population and income growth, world demand for raw materials will ease.Andrew Burns, the leading author of the report, dismissed the idea – widely supported among the industry and international bodies such as the International Energy Agency – that the credit crunch could result in higher prices when the economy recovers as companies cancel supply expansion projects.The bank forecast that world trade – an engine of growth for many developing countries – would contract for the first time since 1982.The World Bank report is significant because it tends to err on the optimistic side with growth forecasts. The longer FT article, "So long, super-cycle," looks at how our latest commodities cycle compares with past ones, and also focuses on the role of emerging markets. We've extracted (no pun intended) some of the juicy bits from this long but worthwhile article:
The common belief in the industry itself, and among most Wall Street analysts, is that the market is undergoing a correction but that the boom years have not ended....But a growing minority disagrees with this rosy view. With its report released on Tuesday, the World Bank has put itself among the most vocal in warning that the commodities boom has come to an end. Some executives in the natural resources industry agree – in private....Although most proponents of this argument see prices remaining well above the lows of the 1990s, they do not forecast a return to the torrid levels of this summer. That is because a more slowly expanding population and weaker rises in income will ease global economic growth – and commodities demand – in the next two decades.Yves here. Demographic changes have not gotten the attention they merit. In addition, China also announced its intent to use the plunge in oil prices to reduce its energy subsidies further next year. China has come to realize that making fuel artificially cheap has made its manufacturers and products energy-inefficient, and it need to move pricing to world levels. Back to the article:
They dismiss the notion that the credit crunch will trigger shortages in the future as companies cancel investment projects. Any increase in demand will first slowly have to absorb the current build-up in dormant capacity as companies cut their production....For its part, the natural resources industry points out that falling supply in some areas and commodities – such as mature oilfields in the North Sea or old gold mines in South Africa – will support prices even if demand is weak. But pessimists say that the rapid fall in demand will leave the system with plenty of spare capacity.Both sides have powerful arguments but history says that commodities booms last about a decade – almost exactly the length of time that oil prices were on the rise.Whatever the disagreements, pessimists and optimists see eye to eye on the next 12-24 months: it looks grim for commodities....“The main difference for commodities is that our view for emerging countries’ near-term economic growth is now more pessimistic,” says Thomas Helbling, an IMF economist who specialises in commodities issues. Relatively high-growth emerging countries consume more energy and other basic products than developed nations as they build infrastructure and embrace new forms of consumption, from cars and washing machines to meat and refrigerators....According to the World Bank, Chinese economic growth will slow to 7.5 per cent in 2009, the lowest rate since 1990. But some bankers and mining executives are even more pessimistic, saying that activity in some sectors has already almost stopped...But for investors, executives and bankers alike, the commodities boom and bust cycles teach that extrapolating today’s events into the future may prove the wrong bet. Ten years ago this week, when oil prices bottomed at $9.64 a barrel, the common wisdom was that commodities prices were heading down. Today’s forecasts could prove equally fallible.PEAK PERIODS OF THE PAST: IN STRENGTH, LENGTH AND SCOPE, IT HAS BEEN THE BOOM OF A CENTURYThe last five years’ commodities price surge has been the most marked of the past century in its magnitude, duration and breadth – with the cost of energy, metals and food all swept upward...The length of the 2003-08 boom has also surprised many. The jumps of the 1950s and 1970s were shorter, although the first world war brought a similarly long period of strength...Yet the sheer size of the rises also stands out. “The magnitude of commodity price increases during the current boom is without precedent,” says the World Bank in its latest report.It notes that prices in real terms – inflation adjusted – have increased by 109 per cent in US dollars since 2003 and 130 per cent since the cyclical low of 1999.By contrast, increases in earlier booms never exceeded 60 per cent, according to the bank’s estimates.From trough to peak in the oil market, prices rose – in nominal terms – by 1,415 per cent between December 1998 and last July.

Spending and Tax Multipliers - 11-12-Mankiw (saída classe)
A key issue facing the new Obama administration is to what extent the economic stimulus should take the form of spending increases versus tax reduction. One way to think about the issue is the size of the fiscal policy multipliers. The multipliers measure bang for the buck--the amount of short-run GDP expansion one gets from a dollar of spending hikes or tax cuts.So what are these multipliers? In their new blog, Bob Hall and Susan Woodward look at spending increases from World War II and the Korean War and conclude that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar. Similarly, the results in Valerie Ramey's research suggest a government spending multiplier of about 1.4. (Valerie does not present her results in multiplier form, but she emails me this translation: "The right column of figure 5A of my paper shows that for a log change of government spending of 1, log GDP rises by 0.28, implying an elasticity of 0.28. To back out the implied multiplier, we can use the fact that government spending averages around 20% of GDP. This implies a multiplier of 1.4.")By contrast, recent research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars. The puzzle is that, taken together, these findings are inconsistent with the conventional Keynesian model. According to that model, taught even in my favorite textbook, spending multipliers necessarily exceed tax multipliers.How can these empirical results be reconciled? One hypothesis is that that compared with spending increases, tax cuts produce a bigger boost in investment demand. This might work through changing relative prices in a direction favorable to capital investment--a mechanism absent in the textbook Keynesian model.Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes (as suggested by Bils and Klenow). This tax cut would reduce the cost of labor and, if labor and capital are complements, increase the demand for capital goods. Thus, the tax cut stimulates demand not only by increasing disposable income and consumption spending (the textbook Keynesian channel) but also by incentivizing more investment spending. A similar result might obtain if the tax cut included, say, an investment tax credit.This hypothesized channel seems broadly consistent with the empirical findings of Blanchard and Perotti, Mountford and Uhlig, Alesina and Ardagna, and Alesina, Ardagna, Perotti, and Schiantarelli. The results of all these authors suggest you need to go beyond the standard Keynesian model to understand the short-run effects of fiscal policy.My advice to Team Obama: Do not be intellectually bound by the textbook Keynesian model. Be prepared to recognize that the world is vastly more complicated than the one we describe in ec 10. In particular, empirical studies that do not impose the restrictions of Keynesian theory suggest that you might get more bang for the buck with tax cuts than spending hikes.
permanent link

Dr. Doom
Published: August 15, 2008
On Sept. 7, 2006, Nouriel Roubini, an economics professor at New York University, stood before an audience of economists at the International Monetary Fund and announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and t continua....

Geoffrey M. Hodgson (After 1929 economics changed: Will economists wake up in 2009?) menciona esta grande matéria (Dr. Doom): Economist Anirvan Banerji responded that Roubini’s predictions did not make use of mathematical models and dismissed his warnings as those of a habitual pessimist (New York Times, August 15, 2008). [......] Chancellors, bloggers, newspapers and magazines may have noticed the relevance of such economists as Keynes and Minsky for today, but have they been rediscovered in departments of economics in the most prestigious universities?

Crescimento subsidiado não é saída para a crise
KENNETH ROGOFFDO "FINANCIAL TIMES"NO PRIMEIRO aniversário da crise econômica mundial, é hora de reexaminar não apenas as estratégias para enfrentá-la mas também o diagnóstico que as embasa. Não se tornou claro, agora, que os principais desafios macroeconômicos que o mundo precisa enfrentar hoje são a demanda excessiva por commodities e uma oferta excessiva de serviços financeiros? Caso a resposta seja afirmativa, então é hora de parar de estimular a demanda agregada e ao mesmo tempo bloquear a reestruturação e a consolidação do sistema financeiro.A alta acentuada na inflação dos preços mundiais das commodities é prova contundente de que a economia mundial continua a crescer rápido demais. Isso nada tem de sinistro. O mundo acaba de passar por possivelmente o mais notável boom de crescimento da história moderna. continua..
KENNETH ROGOFF é professor de economia na Universidade Harvard e foi economista-chefe do Fundo Monetário Internacional.

January 03, 2009
Charles Kindleberger: Anatomy of a Typical Financial Crisis
From Charlie Kindleberger, A Financial History of Western Europe:
p. 90 ff: No discretion was allowed in the issuance of bank notes, however.... Sir Robert Peel, the Prime Minister, first contemplated allowing a relaxing power in the 1844 legislation, but ultimately decided against it.... Peel protected himself... in a letter from Windsor Castle, written on 4 June 1844:
My confidence is unshaken that we have taken all the precautions which legislation can prudently take against a recurrence of a pecuniary crisis. It may occur in spite of our precautions; and if it does and if it be necessary to assume a grave responsibility, I dare say men will be found willing to assume such a responsibility (BPP 1847 [1969], Vol. 2, p. xxix).
The difficulty in making the note issue inelastic... is that it became inelastic at all times, when the requirement in an internal financial crisis is that money be freely available....
The Bank of England came to the rescue of the South Sea Company... belatedly, and at a punishing price..,. to dispose of a dangerous rival. Its recognition of its responsibilites in preventing, or at least mitigating, financial crisis in the public interest took more time. There was a lag in understanding the need to have the money supply inelastic in the long run but elastic in the short. A further question was whose task it was to serve as lender of last resort.
Thomas Ashton has staed that... the Bank of England was already the lender of last resort in the eighteenth century.... It is true that the Bank of England was pressured... but its response was, on the whole, reluctant and defensive.... The Bank occasionally took steps that increased the public's fear... 1745... 1772... 1782... 1793....
Critical debate over who should act as lender of last resort... took place behiind closed doors in December 1825.... [Chancellor] Lord Liverpool, having warned the market... that the speculators were going too far and that the government would not save them... threatened to resign if Exchequer bills were provided.... The emergency required action by someone.... Lord Liverpool... applied enormous pressure on the Bank to force it to issue special advances to merchants against inventories....
The lender of last resort function reached full flower under the Bank Act of 1844. 'Overtrading' which Adam Smith held to be the cause of financial crises--which were in his lexicon 'revulsion' and 'discredit'--produced incidents in 1847, 1857, and 1866.... [M]en of responsibility, as foreseen by Sir Robert Peel, figured out a way to suspend the Bank Act.... [T]he Chancellor of the Exchequer issued a letter to the Bank of England...
p. 270 ff: The macroeconomic system receives some shock--caused by Hyman Minsky, who virtually alone of modern economists is interested in financial instability, a 'displacement' (1982). This displacement can be monetary or real... changes expectations... with respect to the profitability of some range of investments.... [I]t can happen, and historically has happened, that the sum total of all the people reacting to the opportunity is excessive... credit is extended... stimulates business... credit is extended further... euphoria... speculation... more pervasive credit expansion.
Time and time again in these pages it has been stressed that when the macroeconomic system is constrained by a tight supply of money, it creates more, at leaset for a time... bank money, bank notes, bills of exchange, especially chains of bills of exchange, bank deposits, open-book credits, credit cards, certificates of deposit, euro-currencies, and so one....
At some stage... it becomes clear to a few, and then to more, that... positions are extended beyond some limit sustainable in the long run, and that the maintenance of capital gains depends on getting out of assets rising in price ahead of others.... More and more speculators seek to get out of whatever was the object of speculation, to reduce their distended liabilities, and switch into money; and more and more it becomes cleer that not everyone can do so at once. There is a rush, a panic, and a crash--or perhaps the lender of last resort intervenes to make clear it will furnish the market with all the cash it insists it requires. In this circumstance, perhaps belatedly, panic and distress subside....
Historically, the burden of proof runs against a theorist who says that destabilizing speculation is impossible when the record shows displacement, euphoria, distress, panic, and crisis occurring decade after decade, century after century, and noted by such classical observers as Adam Smith in the eighteenth century and Lord Overstone in the nineteenth, quoted with approval by Walter Bagehot (1852 [1978], Vol. 9, p. 273).... Bagehot adds:
Common sense teaches that booksellers should not speculate in hops, or bankers in turpentine; that railways should not be promoted by maiden ladies, or canals by beneficed clergymen... in the name of common sense, let there by common sense (1852 [1978], Vol. 9, p. 275).
But history demonstrates that common sense in these questions is uncommon, at least at ten-year intervals....
Whether there is a theoretical rationale for letting the market find its way out of a panic or not, the historical fact is that panics that have been met most successfully almost invariably found some source of cash to ease the liquidation of assets before prices fell to ruinous levels. An important question is who has responsibility to provide that cash....
The lender of last resort role is riddled with... ambiguity, verging on duplicity. One must promise not to rescue banks and merchant houses that get into trouble, in order to force them to take responsibility for their behavior, and then rescue them when, and if, they do get into trouble for otherwise trouble might spread....
[T]he central bank presumably seeks to follow rules of helping only sound houses with good paper. The dilemma is that if it holds off too long, what had been good paper becomes bad.... Lending to sound houses introduces a note of discretion and judgment... questions of insider-outsider, favoritism, and prejudice.... [T]here are bound to be questions raised as to whehter the Establishment took care of its own and rejected the outsiders and pushy upstarts...

Refuted economic doctrines #1: The efficient markets hypothesis
by John Quiggin on January 3, 2009
Over at my blog, I’ve started a series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion. I’m crossposting here in the hope of getting more discussion, but readers who aren’t interested in econowonk stuff may want to skip this series.
Number One on the list is a topic I’ve covered plenty of times before (in fact, I was writing about it fifteen years ago), the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets.
The hypothesis comes in three forms.
The weak version (which stands up well, though not perfectly, to empirical testing) says that it is impossible to predict future movements in asset prices on the basis of past movements, in the manner supposedly done by sharemarket chartists. While most of what is described by chartists as ‘technical analysis’ is mere mumbo-jumbo, there is some evidence of longer-term reversion to mean values that may violate the weak form of the EMH.
The strong version, which gained some credence during the financial bubble era says that asset prices represent the best possible estimate taking account of all information, both public and private. It was this claim that lay behind the proposal for ‘terrorism futures’ put forward, and quickly abandoned a couple of years ago. It seems unlikely that strong-form EMH is going to be taken seriously in the foreseeable future, given the magnitude of asset pricing failures revealed by the crisis.
For most policy issues, the important issue is the “semi-strong” version which says that asset prices are at least as good as any estimate that can be made on the basis of publicly available information. It follows, in the absence of distorting taxes or other market failures that the best way to allocate scarce capital and other resources is to seek to maximise the market value of the associated assets. Another way of presenting the semi-strong EMH is to say whether or not markets are perfectly efficient, they’re better than any other possible capital allocation method, or at least, better than any practically feasible alternative.
The hypothesis can be tested in various ways. First, it is possible to undertake econometric tests of its predictions. Most obviously, the weak form of the hypothesis precludes the existence of predictable patterns in asset prices (unless predictability is so low that transactions costs exceed the profits that could be gained by trading on them). This test is generally passed. On the other hand, a number of studies have suggested that the volatility of asset prices is greater than is predicted by semi-strong and strong forms of the hypothesis (note to readers – can anyone recommend a good literature survey on this point).
While econometric tests can be given a rigorous justification, they are rarely conclusive, since it is usually possible to get somewhat different results with a different specification or a different data set. Most people are more likely to form their views on the EMH on the basis of beliefs about the presence or absence of ‘bubbles’ in asset prices, that is, periods in which prices move steadily further and further away from underlying values. For those who still believed the EMH, the recent crisis should have shaken their faith greatly. But, although the consequences were less severe, the dotcom bubble of the late 1990s was, to my mind, are more clear-cut and convincing example of an asset price bubble. Anyone could see, and many said, that this was a bubble, but those, like George Soros, who tried to profit by shortselling lost their money when the bubble lasted longer than expected (perhaps long-dated put options would have provided a safer way to bet on an eventual bursting of the bubble, but Soros didn’t try this, and neither did I.)
More important than asset markets themselves is their role in the allocation of investment. As Keynes (allegedly) said, this job is unlikely to be well done when it is a by-product of the activities of a casino. So, if the superficial resemblance of asset markets to gigantic casinos reflects reality, we would expect to see distortions in patterns of savings and investment. The dotcom bubble provides a good example, with around a trillion dollars of investment capital being poured into speculative investments. Some of this was totally dissipated, while much of the remainder was used in a massive, and premature, expansion of the capacity of optical fibre networks (the fraudulent claims of Worldcom played a big role here). Eventually, most of this “dark fibre” bandwidth was taken up, but in investment allocation timing is just as important as project selection.
The dotcom bubble was just one component of a massive asset price bubble that began in the early 1990s and is only now coming to an end. Throughout this period, patterns of savings and investment made little sense. Household savings plunged to zero and below in a number of developed countries (including nearly all English-speaking countries) and the resulting current account deficits were met by borrowing from rapidly growing poor countries like China (standard economics would suggest that capital flows should go in the other direction). The massive growth of the financial sector itself, which accounted for nearly half of all corporate profits by the end of the bubble, diverted physical and particularly human capital from the production of goods and services.
Finally, it is useful to look at the actual operations of the financial sector. Even the strongest advocates of the EMH would not seek to apply it to, say, the Albanian financial sector in the 1990s, which was little more than a series of Ponzi schemes. They would however want to argue that the massively sophisticated global financial markets of today, with the multiple safeguards of domestic and international financial regulation, private sector ratings agencies and the teams of analysts employed by Wall Street investment banks is not susceptible to such systemic problems, and is capable of correcting them quickly as they arise, without any need for large-scale and intrusive government intervention. I’ll leave it to readers to make their own judgements (maybe with some links when I get around to it).
Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. More to follow!

23-01-2009 - do MIT
The crisis and how to fix it: Part 1, causes - Caballero -
The crisis and how to fix it: Part 2, solutions - Caballero -


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