Category Archives: Notes

Pawn Shops, Information Insensitivity, and Debt-on-Debt

In a BIS working paper (January 2015), Bengt Holmstrom summarizes some of the implications of the research on information insensitive debt. He cautions against moves to increase transparency in debt markets and defends the shadow banking system. He explains why opacity and information insensitivity are valuable and argues that debt-on-debt arrangements are (privately) optimal.

It all started with pawn shops:

The beauty lies in the fact that collateralised lending obviates the need to discover the exact price of the collateral. …

Today’s repo markets … are close cousins of pawn brokering with similar risks for the parties involved. … the buyer of the asset (the lender) bears the risk that the seller (the borrower) will not have the money to repurchase the asset and just like the pawnbroker, has to sell the asset in the market instead. The seller bears the risk that the buyer of the asset may have rehypothecated (reused) the posted collateral and cannot deliver it back on the termination date. … the risk that a pawnbroker may sell or lose the pawn was a big issue in ancient times and could explain why the Chinese pawnbrokers were Buddhist monks. …

People often assume that liquidity requires transparency, but this is a misunderstanding. What is required for liquidity is symmetric information about the payoff of the security that is being traded so that adverse selection does not impair the market. …

… stock markets are in almost all respects different from money markets …: risk-sharing versus liquidity provision, price discovery versus no price discovery, information-sensitive versus insensitive, transparent versus opaque, large versus small investments in information, anonymous versus bilateral, small unit trades versus large unit trades. … money markets operate under much greater urgency than stock markets. There is generally very little to lose if one stays out of the stock market for a day or longer. This is one reason the volume of trade is very volatile in stock markets. In money markets the volume of trade is very stable, because it could be disastrous if, for instance, overnight debt would not be rolled over each day. …

… debt-on-debt is optimal … . It is optimal to buy debt as collateral to insure against liquidity shocks tomorrow and it is optimal to issue debt against that collateral tomorrow. In fact, repeating the process over time is optimal, too, so debt is in a very robust sense the best possible collateral. This provides a strong reason for using debt as collateral in the shadow banking system. …

Panics always involve debt. Panics happen when information insensitive debt (or banks) turns into information-sensitive debt.

Nobel Laureates? École Normale Supérieure

In Nature, Tom Clynes reports about research indicating that École Normale Supérieure has the highest proportion of undergraduates that eventually win a Nobel prize. The California Institute of Technology comes second ahead of Harvard, Swarthmore, Cambridge, École Polytechnique, MIT, Columbia, Amherst, and Chicago.

Are We Real?

In the Guardian, Olivia Solon reports about the discussion on whether life as we experience it likely is a simulation.

Pro:

… videogames are becoming more and more sophisticated and in the future we’ll be able to have simulations of conscious entities inside them. … If there are many more simulated minds than organic ones, then the chances of us being among the real minds starts to look more and more unlikely.

… That we might be in a simulation is … a simpler explanation for our existence …

Con:

… if we are in a simulation then we have no clue what the laws of physics are.

Hybris.

On Hygge and Gemütlichkeit

The Economist suggests that Danish Hygge (or German Gemütlichkeit) might go hand in hand with exclusion of strangers.

Denmark’s own natives may rank it top for happiness, but the immigrants in the survey [among expatriates] ranked it 60th in terms of friendliness, 64th for being made to feel welcome, and 67th for the ease of finding friends. … If cultures are obsessed with the joys of relaxing with old friends, perhaps it is because they find it stressful to make new ones.

Triple Coincidence in International Finance

On VoxEU, Stefan Avdjiev, Robert McCauley, and Hyun Song Shin discuss how a focus on net capital flows between countries can mislead policy analysts if they neglect heterogeneity between sectors in a country and/or non-congruence of economic and currency area that is, if they assume the “triple coincidence” between economic area, decision-making unit, and currency area.

The triple coincidence misleads

because it obscures gross flows, …

in that it gives insufficient weight to international funding currencies that are extensively borrowed outside the borders of their home countries …

if it glosses over the relevant decision-making unit by aggregating too much.

Puerto Rico and its Control Board

In the FT, Eric Platt offers an update on the debt situation in Puerto Rico:

  • The U.S. territory carries a USD 70 billion debt burden.
  • It has defaulted multiple times over the past year, “including on bonds backed with a constitutional guarantee.”
  • It did not have access to a court-backed restructuring process until Congress recently passed and President Obama signed the Puerto Rico Oversight, Management and Economic Stability Act (Promesa).
  • A seven-person control board controls the island’s finances and will oversee negotiations with creditors.
  • Puerto Rico has two weeks to submit a turnaround plan to the board.

Grounding

15 years ago, Swissair stopped operating. Many of the fleet’s airplanes were grounded at Zurich airport. Staff and passengers could not understand the world, official Switzerland was in a state of shock, and public perceptions of UBS management which was considered to have acted in treacherous ways, started their long descend.

The movie: Grounding. Werner Enz looks back in the NZZ.

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Cognitive Computing

On IBM Research Labs’ beautiful campus in Rüschlikon near Zurich, researchers are developing “cognitive computing” tools and applications, among others.

An IBM paper written in response to a White House request for information explains:

At IBM, we are guided by the term “augmented intelligence” rather than “artificial intelligence.” It is the critical difference between systems that enhance and scale human expertise rather than those that attempt to replicate all of human intelligence. We focus on building practical AI applications that assist people with well-defined tasks, and in the process, expose a range of generalized AI services on a platform to support a wide range of new applications.

We call our particular approach to augmented intelligence “cognitive computing.” Cognitive computing is a comprehensive set of capabilities based on technologies such as machine learning, reasoning and decision technologies; language, speech and vision technologies; human interface technologies; distributed and high-performance computing; and new computing architectures and devices. When purposefully integrated, these capabilities are designed to solve a wide range of practical problems, boost productivity, and foster new discoveries across many industries. This is what we bring to market today in the form of IBM Watson.

Cognitive computing in the kitchen: IBM chef Watson.

Doubts about Empirical Research

The Economist reports about research by Paul Smaldino and Richard McElreath indicating that studies in psychology, neuroscience and medicine have low statistical power (the probability to correctly reject a null hypothesis). If, nevertheless, almost all published studies contain significant results (i.e., rejections of null hypotheses), then this is suspicious.

Furthermore, Smaldino and McElreath’s research suggests that

the process of replication, by which published results are tested anew, is incapable of correcting the situation no matter how rigorously it is pursued.

With the help of a model of competing research institutes, Smaldino and McElreath simulate how empirical scientific research  progresses. Labs that find more new results also tend to produce more false positives. More careful labs try to rule out false positives but publish less. More “successful” labs are allowed to replicate. As a consequence, less careful labs spread out. Replication—repetition of randomly selected findings—does not stop this process.

poor methods still won—albeit more slowly. This was true in even the most punitive version of the model, in which labs received a penalty 100 times the value of the original “pay-off” for a result that failed to replicate, and replication rates were high (half of all results were subject to replication efforts).

Smaldino and McElreath conclude that “top-performing laboratories will always be those who are able to cut corners”—even in a world with frequent replication. The Economist concludes that

[u]ltimately, therefore, the way to end the proliferation of bad science is not to nag people to behave better, or even to encourage replication, but for universities and funding agencies to stop rewarding researchers who publish copiously over those who publish fewer, but perhaps higher-quality papers.

Monetarism

At the recent Karl Brunner Centenary event, Ernst Baltensperger characterized Monetarism as a set of five convictions:

  • Money matters (as accepted in the neoclassical synthesis)
  • Rules are preferred over discretion (in contrast to the views of Modigliani, Samuelson or Klein), but some flexibility is accepted
  • Inflation and inflation expectations are key (in contrast to traditional Keynesian views)—adaptive expectation formation, parallels to Phelps
  • Money growth targeting is useful—Brunner and Meltzer favored the monetary base, Friedman M1
  • Money, credit and the “details” of financial markets matter for the monetary transmission mechanism—Brunner and Meltzer pushed the credit view, parallels to Tobin

Baltensperger concluded that the macroeconomic mainstream has absorbed many of these convictions, as it has absorbed many pillars of Keynesian thought.

World War I Turned the Swiss Franc Into a Strong Currency

In Die Volkswirtschaft, Ernst Baltensperger and Peter Kugler summarize the history of the Swiss Franc since the mid 19th century:

  • After 1973, the Swiss Franc has been strong. Swiss Franc yields have been lower than what uncovered interest parity would suggest.
  • Before 1914, the Swiss Franc was weak in the sense that it enjoyed only limited credibility. In periods with fixed exchange rates, Swiss Franc yields typically exceeded yields in French Franc or Sterling.
  • Throughout the 20th century, the Swiss Franc appreciated by more than what inflation differentials would suggest, potentially reflecting the Balassa-Samuelson effect.

Pet Health Care

In an NBER working paper, Liran Einav, Amy Finkelstein, and Atul Gupta document similarities between healthcare for humans and pets in the US:

(i) rapid growth in spending as a share of GDP over the last two decades; (ii) strong income-spending gradient; (iii) rapid growth in the employment of healthcare providers; and (iv) similar propensity for high spending at the end of life.

The Trouble with Macroeconomics

The “Trouble with Macroeconomics,” according to a working paper by Paul Romer that is posted on his website, relates to dishonest identification assumptions, in particular in DSGE models used for policy analysis. Romer singles out calibration, assumptions about distribution functions and strong priors as culprits.

Romer argues that

[b]eing a Bayesian means that your software never barfs

and

I agree with the harsh judgment by Lucas and Sargent (1979) that the large Keynesian macro models of the day relied on identifying assumptions that were not credible. The situation now is worse. Macro models make assumptions that are no more credible and far more opaque.

Romer also offers a meta-model of himself as a critic of “post-real models” and “facts with unknown truth value.”

Karl Brunner

The SNB commemorated Karl Brunner’s 100th birthday with a Centenary Event and the first of a new lecture series, the Karl Brunner Distinguished Lecture Series. Allan Meltzer, Benjamin Friedman, Charlie Plosser, and Ernst Baltensperger reviewed Karl Brunner’s life and work at the event; Kenneth Rogoff delivered the lecture.

In the NZZ, Allan Meltzer writes about Karl Brunner. Ditto Kurt Schilknecht.

Favors?

In the FAZ, Patrick Bernau und Manfred Schäfers report that the German Federal Ministry for Economic Affairs invited five research institutes to produce economic forecasts although the call for bids had stated that the Ministry would contract with at most four institutions. Legal experts agree that this procedure is illegal.

The report suggests that the institution that just made it (DIW) is led by Marcel Fratzscher who is politically close to the Minister.

Young Men in the US Work Fewer Hours

More discussion about falling employment of young men in the US:

  • John Rust publicizes the facts in a speech: Unskilled young men spend more time playing video games and less time in the labor market. “In 2015, 22 percent of lower-skilled men aged 21–30 had not worked at all during the prior 12 months.” They live in the basement of their parents’ houses and are not married. (And on his 12-year old son: “If we didn’t ration video games, I am not sure he would ever eat. I am positive he wouldn’t shower.)
  • Jason Richwine argues that the trend is restricted to natives as opposed to immigrants.
  • A critical assessment on We the Pleeple.

One of the first to point to the phenomenon was Bob Hall, for example at the 2015 ASSA meetings in Boston.

Have Banks Become Less Risky?

In BPEA, Natasha Sarin and Larry Summers argue that bank stock has not:

… we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. …

… financial markets may have underestimated risk prior to the crisis … Yet we believe that the main reason for our findings is that regulatory measures that have increased safety have been offset by a dramatic decline in the franchise value of major financial institutions, caused at least in part by these new regulations.

This table is taken from their paper:

bpea-fall-2016-web-sarin-new

However, their finding need not be as bad as it sounds. After all, bank regulators intended to insulate taxpayers against bank failure and to render the financial system more shock proof, not bank equity.

Redistribution From Unexpected Deflation in the Euro Area

In the JEEA 14(4) (August 2016) Klaus Adam and Junyi Zhu argue that

unexpected price-level movements generate sizable wealth redistribution in the Euro Area (EA) … The EA as a whole is a net loser of unexpected price-level decreases, with Italy, Greece, Portugal, and Spain losing most in per capita terms, and Belgium and Malta being net winners. Governments are net losers of deflation, while the household (HH) sector is a net winner … HHs in Belgium, Ireland, Malta, and Germany experience the biggest per capita gains, while HHs in Finland and Spain turn out to be net losers. … relatively young middle class HHs are net losers of deflation, while older and richer HHs are winners. … wealth inequality in the EA increases with unexpected deflation, although in some countries (Austria, Germany, and Malta) inequality decreases due to the presence of relatively few young borrowing HHs. … HHs in high-inflation EA countries hold… systematically lower nominal exposures.

The table reports the estimated effects of a one-time unexpected change in the general price level by 10% (expressed either in thousand EUR per capita, or as a share of GDP); a positive sign indicates a gain from deflation.

Government
(1000 EUR p.c.)		Households
(1000 EUR p.c.)		ROW
(1000 EUR p.c.)		Government
(share of GDP)		Households
(share of GDP)		ROW
(share of GDP)
Euro Area−18.67.810.8−0.730.300.42
Austria−21.711.610.1−0.700.370.32
Belgium−27.640.8−13.2−0.931.37−0.44
Cyprus−9.9−7.217.0−0.52−0.380.89
Finland−3.0−8.411.3−0.10−0.270.37
France−22.310.611.7−0.810.390.43
Germany−17.415.32.2−0.600.530.08
Greece−22.9−1.224.1−1.34−0.071.41
Ireland−19.221.8−2.6−0.540.61−0.07
Italy−23.28.115.1−0.990.350.64
Luxembourg22.712.0−34.70.350.18−0.53
Malta−8.320.1−11.8−0.631.52−0.89
Netherlands−16.5−9.525.9−0.50−0.290.78
Portugal−13.1−0.213.3−0.88−0.010.89
Slovakia−4.82.22.6−0.540.240.29
Slovenia−8.62.95.7−0.560.190.37
Spain−12.4−6.719.1−0.60−0.320.93

Dynamics of the World Income Distribution

In a Resolution Foundation report, Adam Corlett examines the “Elephant Curve.” The curve shows that between 1988 and 2008 income growth in the 70th to 95th percentile range of the world income distribution was much lower than for almost all other percentiles. Since the lower middle class of rich countries is situated around the 80th percentile of the distribution the Elephant curve has been interpreted as evidence for stagnating middle class incomes in the rich countries.

Corlett emphasizes that

  • the country composition in 1988 and 2008 is not the same. Holding it constant the Elephant curve is less pronounced.
  • “Population changes, rather than just income changes, have driven the income growth distribution in the elephant curve.” Holding the relative population size across countries constant the Elephant curve is less pronounced.
  • There is lots of variation across developed economies. “[T]he weak figures for the mature economies as a whole are driven by Japan (reflecting in part its two ‘lost decades’ of growth post-bubble, but primarily due to likely flawed data) and by Eastern European states (with large falls in incomes following the collapse of the Soviet Union after 1988). Looking only at the remaining mature economies, far from stagnation we find average real income growth of 52 per cent with strong growth across the distribution, though slightly higher at the top. [But] there are great differences between these nations. US growth of 41 per cent was notably unequally shared, with low (but not zero) growth for poorer deciles meaning that the US comes closest to matching the stagnation and inequality narrative – despite international trade being much less important on a national level there than elsewhere [my emphasis]. But most people in most other rich countries experienced stronger growth.”

Negative Interest Rates vs. Higher Inflation

On his blog, Ben Bernanke weighs the pros and cons of negative (nominal) interest rates vs. a higher inflation target to create monetary “policy space.” His main points are:

  • Lower rates work immediately. In contrast, a higher inflation target only works once agents’ expectations adjust. A higher target may not be politically tenable a thus, not be credible. In contrast, “institutional changes … [such] as eliminating or restricting the issuance of large-denomination currency, could expand the scope for negative rates.”
  • Both negative rates and higher inflation have negative side effects. But the side effects of negative rates would materialize only during bad recessions.
  • There are reasons to expect that higher inflation would impose a relatively larger burden on the “poor” while negative interest rates would impose a relatively larger burden on the “rich.”
  • The political risks for the Fed associated with a higher inflation target may be substantial.