11/1/2012: Great Moderation or Great Delusion

A recent (December 2011) paper published by CEPR offers a very interesting analysis of the macroeconomic risks propagation in the current crisis. The paper, titled Great Moderation or Great Mistake: Can rising confidence in low macro-risk explain the boom in asset prices? (CEPR DP 8700) by Tobias Broer and Afroditi Kero looks at the evidence on whether the period of Great Moderation in macroeconomic volatility during the period from the mid-1980s (the decline in macroeconomic volatility that is unprecedented in modern history) had an associated impact on the rise of asset prices that accompanied this period, setting the stage for the ongoing crash.

In recent literature, this rise in asset prices, and the crash that followed, have both been attributed to "overconfidence in a benign macroeconomic environment of low volatility" or to excessively optimistic expectations of investors that the lengthy period of macroeconomic stability and upward trending is the 'new normal'. 

The study introduced learning about the persistence of volatility regimes in a standard asset pricing model of investor decision making. "It shows that the fall in US macroeconomic volatility since the mid-1980s only leads to a relatively small increase in asset prices when investors have full information about the highly persistent, but not permanent, nature of low volatility regimes." In other words, in the rational expectations setting with no errors in judgement and perfect foresight (investors are aware that volatility reductions are temporary), there is no bubble forming.

However, when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

Specifically, calibrated model generates pre-collapse rise in asset prices of 77% and overvaluation of assets by 79% over the case of no learning. The subsequent collapse of asset prices is 84% in the case of imperfect information learning.

A pretty nice result! 

11/01/2012: Risk-off or 'Grab that Straw, Man'?

Another day, another historical marker falls under the weight of the euro area mess:

US Treasury auctioned off USD21bn of 10 year notes today achieving the yield of 1.90% - lowest on record for an auction. Cover was 3.19 times the offering, slightly ahead of 3.15 average for previous four 10 year notes auctions. Direct bidders demand was up to 17.4% of sales against the average 10%. 10 year secondary markets yields sliped to 1.91% from 1.97% pre-auction.

Here's the IMF illustration (all charts below are from Cottarelli November 2011 presentation) of the evolution of holdings of US debt:

Which, funnily enough, is pretty diversified when compared to that found in Europe:

But the US yields are, of course, purely irrational:

Then, again, not as irrational as those found in Japan:

Altogether elsewhere, vast... German bund auction - 5 year, €4 billion - attracted cover of 2.24 and the average yield of 0.9%. That is well below inflation - however measured - and even below expected inflation, accounting for the potential slowdown. In other words, investors are now so scared, they are paying German government money to store their cash. In the secondary markets, German 1 year bonds turned negative yield back at the end of November, for the first time in history. German 10-years are currently trading in the 1.87% yield territory. According to FT, 10 year bund yields fell from 3.49% in April 2011 to a low of 1.67% in September last year.

Risk-off raging as EU vacillates... or rather, as its leaders consider how to by-pass Belgian General strike that has derailed their January 30 summit.


Nice one, folks. The insolvent Rome burns, the leaders are having summits galore and the unions are demanding more insolvency, while country output shrinks due to striking.


We are no longer in risk-aversion or even loss-aversion world, we are in a grab-anything-that-might-float world.

10/1/2012: Entrepreneurship and Chaos

In a slight departure from macroeconomic focus of the blog, here are two links to, in my view, pivotal articles on business and entrepreneurship. Pivotal not because they provide the answers, but because they raise questions I suspect will be the most important ones in years to come.

So enjoy:
http://www.inc.com/eric-schurenberg/the-best-definition-of-entepreneurship.html
and
http://www.fastcompany.com/magazine/162/generation-flux-future-of-business

And I would be interested in your views on these as well.

9/1/2012: Week opener: Merkozy continuing to ignore Greek realities

Today's meeting between Sarkozy and Merkel is being framed in the context of continued pressures across the euro area (see report on the meeting here). More ominously - within the context of the euro area leadership duet ignoring the latests warning signs for Greece.

Per Der Spiegel report, IMF has changed its analysis of the Greek rescue package agreed in July 2011 in-line with IMF changes in forecasts for Greek economy in the latest programme review in December 2011. Specifically, IMF lowered its forecast for growth from -3% to -6% GDP.

Der Spiegel cites IMF internal memo in claiming that the Fund is viewing existent Greek programme (including to 50% 'voluntary' haircut on Greek bonds currently under negotiations) as insufficient to stabilize the Greek economy and fiscal situation. The Fund is, reportedly, considering 3 possible options to alleviate the latest set of growth pressures:

• New austerity measures for Athens - a measure that in my view will only exacerbate immediate pressures on Greece and will lead to dangerous destabilization of political situation in the country, leading to even more second order adverse effects on growth (e.g. prolonged strikes and rioting);
• Deeper haircuts on Greek debt held by private institutions - in my opinion this will lead to more contagion from Greece to euro area banks and sovereigns and should be, instead complemented by writedowns of Greek debt held by the ECB, to match existent private sector arrangements;
• Increase in the euro zone bailout funds - in my view, this measure is currently outside the feasibility envelope for Europe and, if attempted, will lead to increased cost of euro area borrowing and have a knock on effect of higher cost of lending to countries currently in the Troika programme. It is also important to note that the EFSF head Klaus Regling is aiming to raise EFSF guarantees to foreign investors to 30%, thus reducing the leverage ratio from 4-5 times to 3 times. This will lower EFSF's theoretical borrowing capacity even further.

The IMF note reports are effectively matched by the statement from the senior Germany Finance Ministry adviser made Saturday, who tole the Greek press that a 50% haircut on Greek debt will not be enough to restore sustainability to Greek fiscal dynamics.

In effect, three of out three IMF 'options' cited will exacerbate the crisis, not resolve it. And there is no Option 4 on the books.

8/1/2012: Irish property prices - History, Equilibrium & Directions to Nowhere Fast

A quick footnote to Brian Lucey's post on house prices:

I often hear people referring to 'historical averages' as price equilibrium indicators. Hmmm... historical and histrionic - here's a snapshot from The Economist data plot:

That pretty much does the trick for anyone still saying we have crossed some sort of the long term equilibrium level... 

7/1/2012: Irish Exchequer Results 2011 - Shifting Tax Burde

In the previous 3 posts we focused on Exchequer receipts, total expenditure by relevant department head, and the trends in capital v current spending. In this post, consider the relative incidence of taxation burden.

Over the years of the crisis, several trends became apparent when it comes to the shifting burden of taxes across various heads. These are summarized in the following table and chart:

To summarize these trends, over the years of this crisis,

• Income tax share of total tax revenue has risen from just under 29% in 2007 to almost 41% in 2011.
• VAT share of total tax revenue has fallen, but not as dramatically as one might have expected, declining from 30.7% in 2007 to 29.7% in 2011
• MNCs supply some 50% of the total corporation tax receipts in Ireland. And they are having, allegedly, an exports boom with expatriated profits up (see QNA analysis last month). Yet, despite this (the exports-led recovery thingy) corporation tax receipts are down (see earlier post on tax receipts, linked above) and they are not just down in absolute terms. In 2007-2011 period, share of total revenue accruing to the corporation tax receipts has fallen from 13.5% to 10.3%. So if there is an exports-led recovery underway somewhere, would, please, Minister Noonan show us the proverbial money?

 So on the tax side of equation, the 'austerity' we've been experiencing is a real one - full of pain for households (whose share of total tax payments now stands at around 58% - some 12 percentage points above it levels in 2007) and the real sweet times for the corporates (the ones that are still managing to make profits to pay taxes, that is). This, perhaps, explains why even those working in protected sectors are talking about their biggest losses coming from tax changes.