Tuesday, May 24, 2016

23/5/16: Greek Debt Sustainability and IMF's Pipe Dreams

IMF outlined its position on Greek debt sustainability, once again stressing the fact - known to everyone with an ounce of brain left untouched by Eurohopium injections from Brussels and Frankfurt : Greek debt is currently unsustainable.

Here are some details of the IMF’s latest encounter with reality:

Firstly, per IMF: Greek “debt was deemed sustainable, but not with high probability, when the first program was adopted in May 2010. Public debt was projected to surge from 115 percent of GDP to a peak of 150 percent of GDP, primarily because the expected internal devaluation implied declining nominal GDP while fiscal deficits were expected to add to the debt burden, but also because of the decision to forgo a private sector debt restructuring (PSI).”

Several things to note here. The extent of internal devaluation required for Greece is a function of several aspects of Euro area policies, most notably, lack of functional independent currency that can absorb - via normal devaluation - some of the shocks; lack of will on behalf of the EU to restructure official debt owed by Greece to EFSF/ESM pair of European institutions and to the ECB; and effective capture of virtually all Greek ‘assistance’ funds within the banking sector and external financing sector, with zero trickle down from these sectors funding to the real economy. In other words, there were plenty of sources for Greek debt non-sustainability arising from EU construct and policies.

Secondly, “the much deeper-than-expected recession necessitated significant debt relief in 2011-12 to maintain the prospect of restoring sustainability. Private creditors accepted large haircuts;… European partners provided very large NPV relief by extending maturities and reducing and deferring interest payments; and Fund maturities were lengthened…”

Which, of course is rather ironic. Lack of functional mechanisms for the recovery in the Greek case included, in addition to those internal to the Greek economic institutions, also the three factors outlined above. In other words, de facto, 2011-2012 restructuring of debt was, at least in part, compensatory measures for exogenous drivers of the Greek crisis. The EU paid for its own poor institutional set up.

However, as IMF notes, “European partners also pledged to provide additional debt relief—if needed—to meet specific debt-to-GDP targets (of 124 percent by 2020 and well under 110 percent by 2022). Critically for the DSA, the Greek government at the time insisted — supported by its European partners — on preserving the very ambitious targets for growth, the fiscal surplus, and privatization, arguing that there was broad political support for the underlying policies.”

Oh dear, per IMF, therefore (and of course the Fund is correct here), the idiocy of shooting Greece in both feet was of not only European making, but also of Greek making. No kidding: Greek own Governments have insisted (and continue to insist) on internecine, unrealistic and outright stupid targets that even the IMF is feeling nauseous about.

“Serious implementation problems caused a sharp deterioration in sustainability, raising fresh doubts about the realism of policy assumptions, especially from mid–2014. The authorities’ hoped-for broad political support for the program did not materialize…  causing long delays in concluding reviews, with only 5 of 16 originally scheduled reviews eventually completed. The problems mounted from mid-2014, with across-the-board reversals after the change of government in early-2015. Staff’s revised DSA—published in June 2015—suggested that the agreed debt targets for 2020-2022 would be missed by over 30 percent of GDP.”

This is clinical. Pre-conditions for August 2015 Bailout 3.0 were set by a combination of external (EU-driven) and internal (domestic politics-driven) factors that effectively confirmed the absolute absurdity of the whole programme. Yes, the IMF is trying to walk away now from sitting at the very same table where all of this transpired. And yes, the IMF deserves to be placed onto the second tier of blame here. Blame is due nonetheless, as the Fund could have attempted to seriously force the EU hand on changing the programme on a number of occasions, but it continued to support the Greek programme, broadly, even while issuing caveats.

But give a cheer to the Tsipras’ Government utter senility: “Critically, …the new government insisted—like its predecessor—that it could garner political support for the necessary underlying reforms.”

And now onto new stuff.

Per IMF’s today’s note: “developments since last summer suggest that a realignment of critical policy and DSA assumptions can no longer be deferred if the DSA is to remain credible. While there certainly has been progress in some areas under the new program that was put in place in August 2015 with support by the ESM, and growth and primary balance out-turns last year were better than expected, the government has not been able to mobilize political support for the overall pace of reforms that would be required to retain the June 2015 DSA’s still ambitious assumptions of a dramatic, rapid, and sustained improvement in productivity and fiscal performance. In all key policy areas—fiscal, financial sector stability, labor, product and service markets—the authorities’ current policy plans fall well short of what would be required to achieve their ambitious fiscal and growth targets.”

Pardon me here, but I seriously doubt the primary problem is with the Greek Government inability to mobilize political support. Actually, the real problem is that the entire framework is so full of imaginary numbers, that any Government in any state of political leadership will have zero chance at delivering on these projections. Yes, the Greeks are blessed with a Government that would’t be able to replace a battery in a calculator, but now, even with fresh batteries no calculator would be able to solve the required growth equations.

So, we have the IMF conclusion: “Consequently, staff believes that a realignment of assumptions with the evident political and social constraints on the pace and scope of adjustment is needed”. In more common parlance, the IMF has to revise its model assumptions as follows:

Primary surplus (aka - austerity):  The IMF recognizes that current tax rates are already too high in Greece (that’s right, the IMF actually finds Greek tax targets to be self-defeating), while expenditure cuts have been ad hoc, as opposed to structural. Thus, with “…tax compliance rates falling precipitously and discretionary spending already severely compressed, staff believes that the additional adjustment needed to allow Greece to run sustained primary surpluses over the long run can only be achieved if based on measures to broaden the tax base and lowering outlays on wages and pensions, which by now account for as much as 75 percent primary spending… This suggests that it is unrealistic to assume that Greece can undertake the additional adjustment of 4½ percent of GDP needed to base the DSA on a primary surplus of 3½ percent of GDP.”

This is bad. And it is direct. But IMF wants to make an even stronger point to get through the thick skulls of Greek authorities and their EU masters: “Even if Greece through a heroic effort could temporarily reach a surplus close to 3½ percent of GDP, few countries have managed to reach and sustain such high levels of primary balances for a decade or more, and it is highly unlikely that Greece can do so considering its still weak policy
making institutions and projections suggesting that unemployment will remain at double digits for several decades.” ‘Heroic’ efforts - even in theory - are not enough anymore, says the IMF. I would suggest they were never enough. But, hey, let’s not split hairs.

So to make things more ‘realistic’, the IMF estimates that primary surplus long run target should be 1.5 percent of GDP - full half of the previously required. Still, even this lower target is highly uncertain (per IMF) as it will require extraordinary discipline from the current and future Greek governments. Personally, I doubt Greece will be able to run even that surplus target for longer than 5 years before sliding into its ‘normal’ pattern of spending money it doesn’t have.

Growth (aka illusionary holy grail of debt/GDP ratios):  “Staff believes that the continued absence of political support for a strong and broad
acceleration of structural reforms suggests that it is no longer tenable to base the DSA on the assumption that Greece can quickly move from having one of the lowest to having the highest productivity growth rates in the eurozone.”

Reasons for doom? 

  1. “…the bank recapitalization completed in 2015 was not accompanied by an upfront governance overhaul to overcome longstanding problems, including susceptibility to political interference in bank management. …in the absence of more forceful actions by regulators, and in view of the exceptionally large level of NPLs [non-performing loans] and high share of Deferred Tax Assets in bank capital, banks will be burdened by very weak balance sheets for years to come, suggesting that they will be unable to provide credit to the economy on a scale needed to support very ambitious growth targets.” There are several problems with this assessment. One: credit creation is unimaginable in the Greek economy today even if the banks were fully reformed because there is no domestic demand and because absent currency devaluation there is also no external demand. Two: despite a massive (95%+ of all bailout funds) injection into the banking sector, Greek NPLs remain unresolved. In a way, the EU simply wasted all the money without achieving anything real in the Greek case.
  2. lack of structural reforms in the collective dismissals and industrial action frameworks “and the still extremely gradual pace at which Greece envisages to tackle its pervasive restrictions in product and service markets are also not consistent with the very ambitious growth assumptions”.

So, on the net, “against this background, staff has lowered its long-term growth assumption to 1¼ percent… Here as well the revised assumption remains ambitious in as much as it assumes steadfastness in implementing reforms that exceeds the experience to date, such that Greece would converge to the average productivity growth in the euro-zone over the long-term.”

So how bad are the matters, really, when it comes to Greek debt sustainability?

Per IMF: “Under staff’s baseline assumptions, there is a substantial gap between projected
outcomes and the sustainability objectives … The revised projections suggest that debt will be around 174 percent of GDP by 2020, and 167 percent by 2022. …Debt is projected to decline gradually to just under 160 percent by 2030 as the output gap closes, but trends upwards thereafter, reaching around 250 percent of GDP by 2060, as the cost of debt, which rises over time as market financing replaces highly subsidized official sector financing, more than offsets the debt-reducing effects of growth and the primary balance surplus”.

A handy chart to compare current assessment against June 2015 bombshell that almost exploded the Bailout 3.0

As a result of the above revised estimates/assumptions: a “substantial reprofiling of the terms of European loans to Greece is thus required to bring GFN down by around 20 percent of GDP by 2040 and an additional 20 percent by 2060,…based on a combination of three measures..:

  • Maturity extensions: An extension of maturities for EFSF, ESM and GLF loans of, up to 14 years for EFSF loans, 10 years for ESM loans, and 30 years for GLF loans could reduce the GFN and debt ratios by about 7 and 25 percent of GDP by 2060 respectively. However, this measure alone would be insufficient to restore sustainability.
  • …Extending the deferrals on debt service further could help reduce GFN further by 17 percent of GDP by 2040 and 24 percent by 2060, and …could lower debt by 84 percent of GDP by 2060 (This would imply an extension of grace periods on existing debt ranging from 6 years on ESM loans to 17 and 20 years for EFSF and GLF loans, respectively, as well as an extension of the current deferral on interest payments on EFSF loans by a further 17 years together with interest deferrals on ESM and GLF loans by up to 24 years). However, even in this case, GFN would exceed 20 percent by 2050, and debt would be on a rising path.
  • To ensure that debt can remain on a downward path, official interest rates would need to be fixed at low levels for an extended period, not exceeding 1½ percent until 2040. …Adding this measure to the two noted above helps to reduce debt by 53 percent of GDP by 2040 and 151 percent by 2060, and GFN by 22 percent by 2040 and 39 percent by 2060, which satisfies the sustainability objectives noted earlier”.

So, in the nutshell, to achieve - theoretical - sustainability even under rather optimistic assumptions and with unprecedented (to-date) efforts at structural reforms, Greece requires a write-off of some 50% of GDP in net present value terms through 2040. Still, hedging its bets for the next 5 years, the IMF notes: “Even under the proposed debt restructuring scenarios, debt dynamics remain highly sensitive to shocks.”

In other words, per IMF, with proposed debt relief, Greece is probabilistically still screwed.

Which, of course, begs a question: why would the IMF not call for simple two-step approach to Greek debt resolution:

  • Step 1: fix interest on loans at zero percent through 2040 or 2050 (placing bonds with the ECB and mandating the ECB monetizes interest on these bonds payable by EFSF/ESM et al). Annual cost would be issuance of ca EUR 2 billion in currency per annum - nothing that would add to the inflationary pressures in the euro area at any point in time;
  • Step 2: require annual assessment of Greek compliance with reforms programme in exchange for (Step 1).

Ah, yes, I forgot, we have an ‘independent’ ECB… right, then… back to imaginative fiscal acrobatics.

One has to feel for the Greeks: screwed by Europe, screwed by their own governments and politically ‘corrected’ by the IMF. Now, wait, of course, all the upset must be directed toward getting rid of the latter. Because the former two cannot be anything else, but friends…

Monday, May 23, 2016

23/5/16: Oil Exporting Countries: Sovereign Risk Metrics

Credit Suisse on fiscal woes of oil exporters:

As a reminder, here are projected 2016 sovereign debt levels across the main oil exporting countries:

Source: IMF

Followed by gross deficits:

Source: IMF

And adding current account balances:

Source: IMF

Now, the list of main oil exporters via http://www.worldstopexports.com/worlds-top-oil-exports-country/ in 2015:

  1. Saudi Arabia: US$133.3 billion (17% of total crude oil exports)
  2. Russia: $86.2 billion (11%)
  3. Iraq: $52.2 billion (6.6%)
  4. United Arab Emirates: $51.2 billion (6.5%)
  5. Canada: $50.2 billion (6.4%)
  6. Nigeria: $38 billion (4.8%)
  7. Kuwait: $34.1 billion (4.3%)
  8. Angola: $32.6 billion (4.1%)
  9. Venezuela: $27.8 billion (3.5%)
  10. Kazakhstan: $26.2 billion (3.3%)
  11. Norway: $25.7 billion (3.3%)
  12. Iran: $20.5 billion (2.6%)
  13. Mexico: $18.8 billion (2.4%)
  14. Oman: $17.4 billion (2.2%)
  15. United Kingdom: $16 billion (2%)
Taking out advanced economies and using the data plotted in three charts above, here are the rankings of each oil exporting country in terms of their sovereign risks (the lower the score, the lower is the risk):

23/5/16: Government Deficits and European 'Rules'

Germany's Ifo Institute prepared a handy table of historical records for EU member states with respect to satisfying the deficit 'break' rule of 3% of GDP (note, I added some side calculations to the original table for averages and for % of years in violation, based on each country accession year):

Enjoy the fact that with exception of Luxembourg, Estonia and Sweden, and adjusting for recession-related causes also Denmark, no country in the EU has managed to fully satisfy the Maastricht criteria.

22/5/16: House Prices & Household Consumption: From One Bust to the Other

In their often-cited 2013 paper, titled “Household Balance Sheets, Consumption, and the Economic Slump” (The Quarterly Journal of Economics, 128, 1687–1726, 2013), Mian, Rao, and Sufi used geographic variation in changes house prices over the period 2006-2009 and household balance sheets in 2006, to estimate the elasticity of consumption expenditures to changes in the housing share of household net worth. In other words, the authors tried to determine how responsive is consumption to changes in house prices and housing wealth. The study estimated that 1 percent drop in housing share of household net worth was associated with 0.6-0.8 percent decline in total consumer expenditure, including durable and non-durable consumption.

The problem with Mian, Rao and Sufi (2013) estimates is that they were derived from a proprietary data. And their analysis used proxy data for total expenditure.

Still, the paper is extremely influential because it documents a significant channel for shock transmission from property prices to household consumption, and thus aggregate demand. And the estimated elasticities are shockingly large. This correlates strongly with the actual experience in the U.S. during the Great Recession, when the drop in household consumption expenditures was much sharper, significantly broader and much more persistent than in other recessions. As referenced in Kaplan, Mitman and Violante (2016) paper (see full reference below), “… unlike in past recessions, virtually all components of consumption expenditures, not just durables, dropped substantially. The leading explanation for these atypical aggregate consumption dynamics is the simultaneous extraordinary destruction of housing net worth: most aggregate house price indexes show a decline of around 30 percent over this period, and only a partial recovery towards trend since.”

With this realisation, Kaplan, Mitman and Violante (2016) actually retests Mian, Rao and Sufi (2013) results, using this time around publicly available data sources. Specifically, Kaplan, Mitman and Violante (2016) ask the following question: “To what extent is the plunge in housing wealth responsible for the decline in the consumption expenditures of US households during the Great Recession?”

To answer it, they first “verify the robustness of the Mian, Rao and Sufi (2013) findings using different data on both expenditures and housing net worth. For non-durable expenditures, [they] use store-level sales from the Kilts-Nielsen Retail Scanner Dataset (KNRS), a panel dataset of total sales (quantities and prices) at the UPC (barcode) level for around 40,000 geographically dispersed stores in the US. …To construct [a] measure of local housing net worth, [Kaplan, Mitman and Violante (2016)] use house price data from Zillow…”

Kaplan, Mitman and Violante (2016)findings are very reassuring: “When we replicate MRS using our own data sources, we obtain an OLS estimate of 0.24 and an IV estimate of 0.36 for the elasticity of non-durable expenditures to housing net worth shocks. Based on Mastercard data on non-durables alone, MRS report OLS estimates of 0.34-0.38. Using the KNRS expenditure data together with a measure of the change in the housing share of net worth provided by MRS, we obtain an OLS estimate of 0.34 and an IV estimate of 0.37 – essentially the same elasticities that MRS find. …Overall, we find it encouraging that two very different measures of household spending yield such similar elasticity estimates.” The numerical value differences between the two studies are probably due to different sources of house price data, so they are not material to the studies.

Meanwhile, “…the interaction between the fall in local house prices and the size of initial leverage has no statistically significant effect on nondurable expenditures, once the direct effect of the fall in local house prices has been controlled for.”

Beyond this, the study separates “the price and quantity components of the fall in nominal consumption expenditures. …When we control for …changes in prices, we find an elasticity that is 20% smaller than our baseline estimates for nominal expenditures.” In other words, deflation and moderation in inflation did ameliorate overall impact of property prices decline on consumption.

Lastly, the authors use a much more broadly-based data for consumption from the Diary Survey of the Consumer Expenditure Survey “to estimate the elasticity of total nondurable goods and services” to the consumer expenditure survey counterpart of expenditures in the more detailed data set used for original estimates. The authors “obtain an elasticity between 0.7 and 0.9 … when applied to total non-durable goods and services.”

Overall, the shock transmission channel that works from declining house prices and housing wealth to household consumption is not only non-trivial in scale, but is robust to different sources of data being used to estimate this channel. House prices do have significant impact on household demand and, thus, on aggregate demand. And house price busts do lead to economic growth drops.

Full paper: Kaplan, Greg and Mitman, Kurt and Violante, Giovanni L., "Non-Durable Consumption and Housing Net Worth in the Great Recession: Evidence from Easily Accessible Data" (May 2016, NBER Working Paper No. w22232: http://ssrn.com/abstract=2777320)

Sunday, May 22, 2016

22/5/16: Lying and Making an Effort at It

Dwenger, Nadja and Lohse, Tim paper “Do Individuals Put Effort into Lying? Evidence from a Compliance Experiment” (March 10, 2016, CESifo Working Paper Series No. 5805: http://ssrn.com/abstract=2764121) looks at “…whether individuals in a face-to-face situation can successfully exert some lying effort to delude others.”

The authors use a laboratory experiment in which “participants were asked to assess videotaped statements as being rather truthful or untruthful. The statements are face-to-face tax declarations. The video clips feature each subject twice making the same declaration. But one time the subject is reporting truthfully, the other time willingly untruthfully. This allows us to investigate within-subject differences in trustworthiness.”

What the authors found is rather interesting: “a subject is perceived as more trustworthy if she deceives than if she reports truthfully. It is particularly individuals with dishonest appearance who manage to increase their perceived trustworthiness by up to 15 percent. This is evidence of individuals successfully exerting lying effort.”

So you are more likely to buy a lemon from a lemon-selling dealer, than a real thing from an honest one... doh...

Some more ‘beef’ from the study:

“To deceive or not to deceive is a question that arises in basically all spheres of life. Sometimes the stakes involved are small and coming up with a lie is hardly worth it. But sometimes putting effort into lying might be rewarding, provided the deception is not detected.”

However, “whether or not a lie is detected is a matter of how trustworthy the individual is perceived to be. When interacting face-to-face two aspects determine the perceived trustworthiness:

  • First, an individual’s general appearance, and 
  • Second, the level of some kind of effort the individual may choose when trying to make the lie appear truthful. 

The authors ask a non-trivial question: “do we really perceive individuals who tell the truth as more trustworthy than individuals who deceive?”

“Despite its importance for social life, the literature has remained surprisingly silent on the issue of lying effort. This paper is the first to shed light on this issue.”

The study actually uses two types of data from two types of experiments: “An experiment with room for deception which was framed as a tax compliance experiment and a deception-assessment experiment. In the compliance experiment subjects had to declare income in face-to-face situations vis-a-vis an officer, comparable to the situation at customs. They could report honestly or try to evade taxes by deceiving. Some subjects received an audit and the audit probabilities were influenced by the tax officer, based on his impression of the subject. The compliance interviews were videotaped and some of these video clips were the basis for our deception-assessment experiment: For each subject we selected two videos both showing the same low income declaration, but once when telling the truth and once when lying. A different set of participants was asked to watch the video clips and assess whether the recorded subject was truthfully reporting her income or whether she was lying. These assessments were incentivised. Based on more than 18,000 assessments we are able to generate a trustworthiness score for each video clip (number of times the video is rated "rather truthful" divided by the total number of assessments). As each individual is assessed in two different video clips, we can exploit within-subject differences in trustworthiness. …Any difference in trust-worthiness scores between situations of honesty and dishonesty can thus be traced back to the effort exerted by an individual when lying. In addition, we also investigate whether subjects appear less trustworthy if they were audited and had been caught lying shortly before. …the individuals who had to assess the trustworthiness of a tax declarer did not receive any information on previous audits.

The main results are as follows:

  • “Subjects appear as more trustworthy in compliance interviews in which they underreport than in compliance interviews in which they report truthfully. When categorizing individuals in subjects with a genuine dishonest or honest appearance, it becomes obvious that it is mainly individuals of the former category who appear more trustworthy when deceiving.”
  • “These individuals with a dishonest appearance are able to increase their perceived trustworthiness by up to 15 percent. This finding is in line with the hypothesis that players with a comparably dishonest appearance, when lying, expend effort to appear truthful.”
  • “We also find that an individual’s trustworthiness is affected by previous audit experiences. Individuals who were caught cheating in the previous period, appear significantly less trustworthy, compared to individuals who were either not audited or who reported truthfully. This effect is exacerbated for individuals with a dishonest appearance if the individual is again underreporting but is lessened if the individual is reporting truthfully.”

21/5/16: Manipulating Markets in Everything: Social Media, China, Europe

So, Chinese Government swamps critical analysis with ‘positive’ social media posts, per Bloomberg report: http://www.bloomberg.com/news/articles/2016-05-19/china-seen-faking-488-million-internet-posts-to-divert-criticism.

As the story notes: “stopping an argument is best done by distraction and changing the subject rather than more argument”.

So now, consider what the EU and European Governments (including Irish Government) have been doing since the start of the Global Financial Crisis.

They have hired scores of (mostly) mid-educated economists to write, what effectively amounts to repetitive reports on the state of economy . All endlessly cheering the state of ‘recovery’.

In several cases, we now have statistics agencies publishing data that was previously available in a singular release across two separate releases, providing opportunity to up-talk the figures for the media. Example: Irish CSO release of the Live Register stats. In another example, the same data previously available in 3 files - Irish Exchequer results - is being reported and released through numerous channels and replicated across a number of official agencies.

The result: any critical opinion is now drowned in scores of officially sanctioned presentations, statements, releases, claims and, accompanied by complicit media and professional analysts (e.g. sell-side analysts and bonds placing desks) puff pieces.

Chinese manipulating social media, my eye… take a mirror and add lights: everyone’s holding the proverbial bag… 

21/5/16: Euro Area Income per Capita: Is the Crisis Finally Over?

Has euro area recovered from the crisis on a per-capita basis? 

Let’s take a look at the latest data available from the Eurostat, covering the period through 4Q 2015.

Looking at the Nominal gross disposable income per capita first: in 4Q 2015, income per capita in the euro area stood at +6.67 percent premium over the pre-crisis peak (measured as an average of 4 highest pre-crisis quarters) and at +3.86 percent premium to the overall highest pre-crisis quarter reading. This is not new: the measure attained its pre-crisis peak within 6 quarters following the peak quarter (3Q 2008). So by this metric, the answer to the above question is ‘Yes’.

Now, consider Real gross disposable income per capita: in 4Q 2015, real income per capita in the euro area was still down 0.57 percent on pre-crisis peak (based on 4 quarters pre-crisis peak average) and down 0.72 percent on pre-crisis peak quarter. Given the peak quarter was in 1Q 2008, we are now into 31 quarters of a crisis and counting. Notably, due to deflation at the height of the crisis, real disposable per capita income actually reached above the pre-crisis peak in 3Q 2009, and as of 4Q 2015, real disposable income per capita in the euro area is down on that reading some 1.31 percent. So by real (inflation-adjusted) metric, the answer to the above question is ’No’.

Lastly, consider Real actual final consumption per capita: in 4Q 2015, real consumption per capita in the euro area was 0.25 percent below pre-crisis peak (for peak measured as an average of four quarters including the peak quarter); and it is down 0.52 percent on pre-crisis peak quarter. As with real income per capita, we now into 31 quarters of below-peak real consumption, so the crisis goes on, judging by this metric.

Here’s a chart to illustrate:

21/5/16: Banks Deposit Insurance: Got Candy, Mate?…

Since the end of the [acute phase] Global Financial Crisis, European banking regulators have been pushing forward the idea that crisis response measures required to deal with any future [of course never to be labeled ‘systemic’] banking crises will require a new, strengthened regime based on three pillars of regulatory and balance sheet measures:

  • Pillar 1: Harmonized regulatory supervision and oversight over banking institutions (micro-prudential oversight);
  • Pillar 2: Stronger capital buffers (in quantity and quality) alongside pre-prescribed ordering of bailable capital (Tier 1, intermediate, and deposits bail-ins), buffered by harmonized depositor insurance schemes (also covered under micro-prudential oversight); and
  • Pillar 3: Harmonized risk monitoring and management (macro-prudential oversight)

All of this firms the core idea behind the European System of Financial Supervision. Per EU Parliament (http://www.europarl.europa.eu/atyourservice/en/displayFtu.html?ftuId=FTU_3.2.5.html): “The objectives of the ESFS include developing a common supervisory culture and facilitating a single European financial market.”

Theory aside, the above Pillars are bogus and I have commented on them on this blog and elsewhere. If anything, they represent a singular, infinitely deep confidence trap whereby policymakers, supervisors, banks and banks’ clients are likely to place even more confidence at the hands of the no-wiser regulators and supervisors who cluelessly slept through the 2000-2007 build up of massive banking sector imbalances. And there is plenty of criticism of the architecture and the very philosophical foundations of the ESFS around.

Sugar buzz!...

However, generally, there is at least a strong consensus on desirability of the deposits insurance scheme, a consensus that stretches across all sides of political spectrum. Here’s what the EU has to say about the scheme: “DGSs are closely linked to the recovery and resolution procedure of credit institutions and provide an important safeguard for financial stability.”

But what about the evidence to support this assertion? Why, there is an fresh study with ink still drying on it via NBER (see details below) that looks into that matter.

Per NBER authors: “Economic theories posit that bank liability insurance is designed as serving the public interest by mitigating systemic risk in the banking system through liquidity risk reduction. Political theories see liability insurance as serving the private interests of banks, bank borrowers, and depositors, potentially at the expense of the public interest.” So at the very least, there is a theoretical conflict implied in a general deposit insurance concept. Under the economic theory, deposits insurance is an important driver for risk reduction in the banking system, inducing systemic stability. Under the political theory - it is itself a source of risk and thus can result in a systemic risk amplification.

“Empirical evidence – both historical and contemporary – supports the private-interest approach as liability insurance generally has been associated with increases, rather than decreases, in systemic risk.” Wait, but the EU says deposit insurance will “provide an important safeguard for financial stability”. Maybe the EU knows a trick or two to resolve that empirical regularity?

Unlikely, according to the NBER study: “Exceptions to this rule are rare, and reflect design features that prevent moral hazard and adverse selection. Prudential regulation of insured banks has generally not been a very effective tool in limiting the systemic risk increases associated with liability insurance. This likely reflects purposeful failures in regulation; if liability insurance is motivated by private interests, then there would be little point to removing the subsidies it creates through strict regulation. That same logic explains why more effective policies for addressing systemic risk are not employed in place of liability insurance.”

Aha, EU would have to become apolitical when it comes to banking sector regulation, supervision, policies and incentives, subsidies and markets supports and interventions in order to have a chance (not even a guarantee) the deposits insurance mechanism will work to reduce systemic risk not increase it. Any bets for what chances we have in achieving such depolitization? Yeah, right, nor would I give that anything above 10 percent.

Worse, NBER research argues that “the politics of liability insurance also should not be construed narrowly to encompass only the vested interests of bankers. Indeed, in many countries, it has been installed as a pass-through subsidy targeted to particular classes of bank borrowers.”

So in basic terms, deposit insurance is a subsidy; it is in fact a politically targeted subsidy to favor some borrowers at the expense of the system stability, and it is a perverse incentive for the banks to take on more risk. Back to those three pillars, folks - still think there won’t be any [though shall not call them ‘systemic’] crises with bail-ins and taxpayers’ hits in the GloriEUs Future?…

Full paper: Calomiris, Charles W. and Jaremski, Matthew, “Deposit Insurance: Theories and Facts” (May 2016, NBER Working Paper No. w22223: http://ssrn.com/abstract=2777311)

21/5/16: Voters selection biases and political outcomes

A recent study based on data from Austria looked at the impact of compulsory voting laws on voter quality.

Based on state and national elections data from 1949-2010, the authors “show that compulsory voting laws with weakly enforced fines increase turnout by roughly 10 percentage points. However, we find no evidence that this change in turnout affected government spending patterns (in levels or composition) or electoral outcomes. Individual-level data on turnout and political preferences suggest these results occur because individuals swayed to vote due to compulsory voting are more likely to be non-partisan, have low interest in politics, and be uninformed.”

In other words, it looks like there is a selection bias being triggered by compulsory voting: lower quality of voters enter the process, but due to their lower quality, these voters do not induce a bias away from state quo. Whatever the merit of increasing voter turnouts via compulsory voting requirements may be, it does not appear to bring about more enlightened choices in policies.

Full study is available here: Hoffman, Mitchell and León, Gianmarco and Lombardi, María, “Compulsory Voting, Turnout, and Government Spending: Evidence from Austria” (May 2016, NBER Working Paper No. w22221: http://ssrn.com/abstract=2777309)

So can you 'vote out' stupidity?..

Saturday, May 21, 2016

20/5/16: Business Owners: Not Great With Counterfactuals

A recent paper, based on a “survey of participants in a large-scale business plan competition experiment, [in Nigeria] in which winners received an average of US$50,000 each, is used to elicit beliefs about what the outcomes would have been in the alternative treatment status.”

So what exactly was done? Business owners were basically asked what would have happened to their business had an alternative business investment process taken place, as opposed to the one that took place under the competition outcome. “Winners in the treatment group are asked subjective expectations questions about what would have happened to their business should they have lost, and non‐winners in the control group asked similar questions about what would have happened should they have won.”

“Ex ante one can think of several possibilities as to the likely accuracy of the counterfactuals”:

  1. “…business owners are not systematically wrong about the impact of the program, so that the average treatment impact estimated using the counterfactuals should be similar to the experimental treatment effect. One potential reason to think this is that in applying for the competition the business owners had spent four days learning how to develop a business plan… outlining how they would use the grant to develop their business. The control group [competition losers] have therefore all had to previously make projections and plans for business growth based on what would happen if they won, so that we are asking about a counterfactual they have spent time thinking about.”
  2. ”…behavioral factors lead to systematic biases in how individuals think of these counterfactuals. For example, the treatment group may wish to attribute their success to their own hard work and talent rather than to winning the program, in which case they would underestimate the program effect. Conversely they may fail to take account of the progress they would have made anyway, attributing all their growth to the program and overstating the effect. The control group might want to make themselves feel better about missing out on the program by understating its impact (...not winning does not matter that much). Conversely they may want to make themselves feel better about their current level of business success by overstating the impact of the program (saying to themselves I may be small today, but it is only because I did not win and if I had that grant I would be very successful).”

The actual results show that business owners “do not provide accurate counterfactuals” even in this case where competition awards (and thus intervention or shock) was very large.

  • The authors found that “both the control and treatment groups systematically overestimate how important winning the program would be for firm growth… 
  • “…the control group thinks they would grow more had they won than the treatment group actually grew”
  • “…the treatment group thinks they would grow less had they lost than the control group actually grew” 

Or in other words: losers overestimate benefits of winning, winners overestimate the adverse impact from losing... and no one is capable of correctly analysing own counterfactuals.

Full paper is available here: McKenzie, David J., Can Business Owners Form Accurate Counterfactuals? Eliciting Treatment and Control Beliefs About Their Outcomes in the Alternative Treatment Status (May 10, 2016, World Bank Policy Research Working Paper No. 7668: http://ssrn.com/abstract=2779364)

20/5/16: Migrating Extremism: Long Run Impact on Voters Preferences

What happens when there is a systemic pattern of migration across borders and geographies that captures migration by political extremists?

This is neither a trivial question nor an esoteric one. It is non-trivial, because, to the best of my knowledge, we are yet to have a good understanding of what happens in the aftermath of military and political efforts to curb extremism. Curbing extremism pushes some of it into underground, but if attempts to curb extremism are not uniform across various geographies, it also incentivises selective migration of large numbers of extremists to those locations, where the efforts to curb their ideologies and behaviour are less strong. If so, when such a migration is feasible on large enough scale, asymmetric treatment of extremists across two geographies can lead to a concentration of extremists in that geography where they are treated more leniently.

This is the logic. What about the evidence?

Here is a fascinating study by Ochsner, Christian and Roesel, Felix, titled Migrating Extremists (March 10, 2016) published so far as a CESifo Working Paper (Series No. 5799: http://ssrn.com/abstract=2763513).

Quoting their abstract (emphasis is mine):

  • "We show that migrating extremists shape political landscapes toward their ideology in the long run
  • "We exploit the unexpected division of the state of Upper Austria into a US and a Soviet occupation zone after WWII. Zoning prompts large-scale Nazi migration to US occupied regions
  • "Regions that witnessed a Nazi influx exhibit significantly higher voting shares for the right-wing Freedom Party of Austria (FPÖ) throughout the entire post-WWII period, but not before WWII. 
  • "We can exclude other channels that may have affected post-war elections, including differences in US and Soviet denazification and occupation policies, bomb attacks, Volksdeutsche refugees and suppression by other political parties. 
  • "We show that extremism is transmitted through family ties and local party branches. We find that the surnames of FPÖ local election candidates in 2015 in the former US zone are more prevalent in 1942 phonebook data (Reichstelefonbuch) of the former Soviet zone compared to other parties."
This is pretty much nuclear. Migration of individuals holding extremist beliefs, when systematically biased in favour of a specific location, does lead to concentration of extremist voters and such concentration is robust over time. Big lessons to be learned for today's migration regulation and institutional environment, as well as the systems of incentives and pressures that drive the migrant selection mechanisms.

Wednesday, May 18, 2016

17/5/16: US Earnings Recession: Four Quarters Long... but How Much Longer?

Recently, I have been highlighting in my Risk & Resilience course for MBAs at MIIS and on this blog the perils of corporate earnings gaming, including the rather worrying trend toward companies posting negative net cash flows (basically using debt to fund shares repurchases).

Here are two of my lecture slides from two weeks ago:

And to add to the pile of evidence, as 1Q 16 earnings rolled in, the numbers were coming in at a frankly put brutal squeeze: we had the fourth consecutive quarter for the S&P 500 earnings running in the red, with 1Q 16 decline being the steepest since 2008-2009 at 6.3%:

However, some interesting insight on the matter of forward earnings guidance was recently published by the Deutsche Bank Research and here is a link to the article discussing it: http://www.valuewalk.com/2016/05/earnings-q1-marks-darkest-hour-just-dawn-says-db/.

Yes, DB's model for earnings for S&P500 is an interesting one. No, without seeing actual standard econometric tests, I can't tell if it makes any sense in reality or not (just because it has high R-sq means diddly nada without knowing how the residuals behave). And no, I am not sure I am buying the idea of 'all factors in favour' arguments presented by DB Research. I am, however, pretty certain that probabilistically a bet should be for more moderate earnings performance in 2Q compared to 1Q, which of course will prompt DB Research lads cheering confirmation of their own model. So I am skeptical, but... still, the article is worth a read.