31/8/2012: Financial Innovation : Positives v Negatives

Following on my previous post, here's a new paper by Frankin Allen titled "Trends in Financial Innovation and Their Welfare Impact: An Overview" (link here) published in the European Financial management (vol 18, issue 4).

Core paper findings are:

• "There is a fair amount of evidence that financial innovations are sometimes undertaken to create complexity and exploit the purchaser... As far as the financial crisis that started in 2007 is concerned, securitization and subprime mortgages may have exacerbated the problem.  
• "However, financial crises have occurred in a very wide range of circumstances, where these and other innovations were not important.  
• "There is evidence that in the long run financial liberalization has been more of a problem than financial innovation.  
• "There are also many financial innovations that have had a significant positive effect.  
• "These include venture capital and leveraged buyout funds to finance businesses.  In addition, financial innovation has allowed many improvements in the environment and in global health." 

The paper concludes that "On balance it seems likely its effects have been positive rather than negative."

I find the arguments strained. Much of the financial innovation that Allen declares to be positive is innovation that is driven directly by either force of the states or co-financed by the states. Thus these forms of innovation are not really innovative at all, but superficial. For example - debt-for-nature swaps are hardly a form of financial innovation but rather a form of state subsidy. Likewise, much of carbon permits trading is driven by restrictions imposed by the states via coercive systems. These might be positive - the point is not to dispute their social or environmental or economic value - but they are not what I would term 'financial innovations'.

About the only positive financial innovation that Allen cites that does not involve such state interventions is leveraged buyout. Allen does cite evidence that this had a positive effect, but in the periods immediately preceding some financial crises (the latest one being case in point, as was Japan's crisis of the 1990s and Nordic countries crises of the early 1990s etc) leveraged buyouts carry excessive leverage. Thus, the only unequivocally positive effect such buyouts might have at the times of rising debt overhang, in my view, is the effect of triggering future insolvencies that clear the path (via creative destruction) to new or more efficient incumbent firms growth. This positive effect, however, has little or nothing to do with the financial innovation per se.

Lastly, let me point that I am not disputing that some (the issue is really more of how much and of what variety) financial innovation is positive, but that Allen's article fails really to prove his hypothesis. Neither does it do any justice to the article to state that "the long run financial liberalization has been more of a problem than financial innovation" without actually proving this.

30/8/2012: Does Banking & Financial (De)regulation iImpact Income Inequality?

A new paper, titled "Bank Regulations and Income Inequality: Empirical Evidence", by Manthos D. Delis, Iftekhar Hasan and Pantelis Kazakis (Bank of Finland Research Discussion Paper 18/2012, linked here) studied the effects of financial regulations (deregulation) on income inequality in 91 countries over the period of 1973-2005.

The study yields some very interesting results (emphasis is mine):

• "In general, the liberalization policies from the 1970s through the early 2000s have contributed significantly to containing income inequality."
• "... Abolishing credit controls decreases income inequality substantially, and this effect is long- lasting."
• "Interest-rate controls and tighter banking supervision decrease income inequality; however, these effects fade away in the long term."
• "For banking supervision, the negative effect on inequality [higher supervision leads to lower inequality] is reversed in the long run, a pattern associated with stricter capital requirements that tend to lower the availability of credit". 
• "... Abolishing entry barriers and enhancing privatization laws seem to lower income inequality only in developed countries."
• "... The liberalization of securities markets {expanding securitization] increases income inequality." 

What are the policy implications of these findings?

• "Bank regulations and associated reforms aim at enhancing the creditworthiness of banks and at improving the stability of the financial sector. Several studies over the last decade show that regulations do matter in shaping bank risk (e.g., Laeven and Levine, 2009; Agoraki et al., 2009) or in affecting bank efficiency (Barth et al., 2010) and the probability of banking crises (e.g., Barth et al., 2008)."
• "Yet, what if bank regulations have other real effects on the economy besides those associated with banking stability? And, more important, what if these real effects counteract the intended stabilizing effects?"

Two issues should be considered in answering these questions:

1. "The literature on the relationship between bank regulations and financial stability is inconclusive. In fact, different types of regulation may have opposing effects on financial stability, according to the existing research."
2. "... even if we assume that bank regulations like more stringent market-discipline requirements lower banks' risk-taking appetite and enhance stability (Barth et al., 2008), the empirical findings here suggest that these effects are asymmetric and certain liberalization policies (i.e., liberalization of securities markets) or regulation policies (i.e., higher capital requirements) actually increase income inequality. That is, banks pass the increased costs of higher risks (coming from the liberalization of securities markets) and higher capital requirements on to the relatively lower-income population that lacks good credit and collateral. In other words a trade-off between banking stability and inequality may be present" [Note: this trade-off, I would argue, is most certainly a problem for Ireland today, with future borrowers operating in the environment of reduced family wealth due to property bust and financial assets depletion]. 

"Given the contemporary discussion surrounding (i) the rebirth of Glass-Steagall-type regulatory reforms as they relate to securities trading, and (ii) the discussions under Basel III to increase the risk-adjusted capital base of banks, there may be more to think about before taking those steps."

"On the good side, three clear suggestions emerge from this paper and are also consistent with the findings of Beck et al. (2010)": 

1. "... the liberalization of banking markets, primarily through abolition of credit controls, helps the poor get easier access to credit. This in turn allows them to escape the poverty trap and substantially raise their incomes." 
2. "... appropriate prudential regulation should provide less costly incentives to banks to increase regulatory discipline without hurting the relatively poor. Information technologies that would lower the cost of transparency and more effective onsite supervision that would enhance the trust in the banking system may help achieve this goal."
3. "... economies first need a certain level of economic and institutional development to see any positive effect of the abolishment of entry restrictions and privatizations on equality..."

30/8/2012: 22 quarters of Europe standing still

2007-present is the period during which the advanced economies world barely moved in terms of economic growth. And this is true especially for the EU27 and the euro area 17. The next three charts document the 22 quarters during which Europe stood still:

(All charts represent author own calculations based on data sourced from the OECD)

29/8/2012: Some facts about Irish average earnings: Q2 2012

Q2 2012 earnings and working hours data for Ireland has been released today by the CSO. Here are top changes and trends:

• Average hourly earnings were €21.91 in Q2 2012 compared with €21.90 in Q1 2011, representing no real change over the year. [Note: either CSO has not heard of inflation, or there was no inflation in Ireland Q2 2011-Q2 2012]
• Average weekly paid hours were 31.4 in Q2 2012, which was the same as those recorded in Q2 2011.
• Public sector numbers were 380,800 in Q2 2012, a fall of 25,800 (-6.3%) from Q2 2011 when the total was 406,600 (including temporary Census field staff).

The above are straight from CSO analysis. Excluding census workers, public sector (including semi-states) employment stood at 380,800 in Q2 2012 down on 401,300 in Q2 2011 and on 421,400 in Q2 2008 - a decline of 20,500 y/y of which 17,600 came from outside semi-state bodies.

Table below lists changes in earnings in broad sectors:

However, on aggregate, year on year to Q2 2012, per CSO:

• Weekly earnings in the private sector fell by 0.5% annually, compared with an increase of 2.8% in the public sector (including semi-state organisations) over the year, bringing, average weekly earnings in Q2 2012 to €611.66 and €918.99 respectively. 
• In the three years to Q2 2012 public sector earnings have fallen by €27.10 (-2.9%). This compares with a decrease of €24.95 (-3.9%) in private sector average weekly earnings in the four years since Q2 2008.

Here's the chart showing decomposition / breakdown of declines in public sector employment:

In Q2 2009, the peak year for average weekly earnings in the public sector, the gap between private sector average weekly earnings (€618.08) and public sector average weekly earnings (€946.09) was 53.07% in favour of the latter. In Q2 2012 the gap was 50.3% - slightly smaller, but not significantly so and factoring in that between 2009 and 2012 many more senior (higher paid and more experienced) public sector employees have retired (including via incentivized early retirement schemes), leaving the workforce in the public sector less skilled and experienced than it was in 2009, the gap has probably increased, like-for-like. Also, the same is exacerbated by the heavy younger workers losses of jobs in the private sector, which has left private sector workforce on average probably more experienced and senior in tenure than prior to the crisis.

In Q2 2008, the gap was 46.2% which was lower than what we are observing today.

Remember, we are being told that everyone should take proportional 'pain'...

29/8/2012: Spot that 'engine for growth'

We keep hearing, usually from the European officials, and at times of referenda - from domestic politicians - that the EU and the euro are the drivers for growth and prosperity. Even today, in his op-ed, ECB chief Mario Draghi referenced euro as a driver of prosperity.

So let's do a simple exercise, take pre-crisis peak and history of growth in nominal euro area GDP and see where would the region have been if it were an 'engine for growth' comparable to relatively weak G7 states (A2), other advanced economies ex-G7 and the euro area (A1), and 1990-2009 world growth average (A3).

Chart below illustrates:

Here's an interesting fact: the advanced economies ex-G7 and euro area path, even after the crisis is factored in is almost identical to the world growth path. But the euro area path is underperforming the G7 path by 2 years in terms of regaining the pre-crisis peak.

Note: all data is taken from and/or computed on the absis of the IMF WEO database.

Caveats are many - this is hardly a deep analysis, so be warned. But by any comparatives, this does not support the proposition of the euro area as an engine for growth.

Let's do another mental exercise. Suppose we ignore the fact that euro area actually expanded since 2004 in terms of membership 9adding very insignificant overall boost to the region GDP of 1.5-1.7%). Assume that post 2004 there are two possible growth rates that apply:

• Average growth rate between 1993 and 2004 to reflect pre-euro area era and
• Average growth rate for 2004-2012 to reflect euro area era

Here's where the two assumptions lead us:

Again, where's that engine for growth?

Please note: the argument that 'absent euro things would/could have been much worse' is vacuous. We don't say Mercedes AMG is an 'engine for speed' by implying that it delivers non-zero speed. We claim this by comparatives to other functioning vehicles.

Lastly, let's compare like-for like. Here's actual (including IMF forecasts for 2012-2017) GDP data for G7 countries (excluding Germany, France and Italy), and EA3 members of G7 (Germany, France and Italy), with an added line for G7 countries ex-EA3 and Japan:

Obviously, an engine for growth should have at very least achieved some comparable performance for EA3 to that of its peers? Err... not really. And worse, taking 1999 as a base date (the year of EA3 adopting the euro officially) yields very similar qualitative results.

29/8/2012: Slovenia & Ireland lead in banks-related risks

According to latest data from the Euromoney, Slovenia now leads the rise in bank-related risks in Europe. Here's a chart mapping declines in scores across Europe (lower score implies higher risk):

It is worth noting that Ireland shows the second largest risk increase  after Slovenia in absolute level terms, but the largest in percentage terms.

29/8/2012: H1 figures for trade show effect of the patent cliff

A very good analysis of Irish external trade figures for trade in goods and the effect of the patent cliff on trade balance from Dr. Chris van Egeraat, Department of Geography and NIRSA, NUI Maynooth in FinFacts today: link here. 

Readers of this blog and my (now sadly defunct) Sunday Times column would have spotted my interest in the subject. Dr Van Egeraat presents H1 figures for 2012 - first available this month - to show the effect.

29/8/2012: Corporate Governance & Transparency in EU27

A new study, published in the International Journal of Business Research (link here), has ranked 27 EU countries' corporate governance codes in terms of transparency levels required. According to authors, the empirical study conducted "that approaches corporate governance from regulatory perspective ...by analyzing all codes currently enforceable at European Union level, has two main goals focused on transparency and disclosure provisions settled by these" which implies that the study is "more comprehensive in these respects than prior related research focused on the same topic".

The main aspect of the study is "to define particular [corporate governance & transparency] disclosure groups [of countries] according to the level of transparency required and to classify all analyzed codes into these clusters."

The study modeled "the average value of disclosure indices for each disclosure group created" (Avg.D&T S_Index), basically as a metric of "similitude between them and OECD principles as regards the compliance with disclosure and transparency requirements".

"Consequently, we divided our sample of corporate governance codes according to their disclosure indices into six different groups revealing a level of disclosure from "very high level" to "insignificant level". The distribution of corporate governance codes into the disclosure groups thus created are presented in Table III, together with the average values of disclosure indices calculated for each group (Avg.D&T S_Index) and the average scores for the independent variables, revealing the level of disclosure depending on codes' issuers type (IT) and countries' legal regimes (LR1 and [LR.sub.1])." 

In the above 

• "IT (Issuer Type), the following four identities being considered: "Composite", made of groups that contain representatives from at least two of the subsequent groups, "Government", referring to national legislatures or governmental commission/ministries, "Exchange", represented by national stock exchanges and "Industry", referring to industry or trade associations and groups, as in prior related literature;"
• "LR (Legal Regime), in this respect being used classifications made by both La Porta, et al. (1997), who distinguished between "Common law", "German civil", "French civil", "Former socialist" and "Scandinavian civil" (values assigned to variable LR1) and Cicon et al. (2010), who introduced two new legal regimes ("Baltic civil" and "Global governance practices") instead of "Former socialist" and "Scandinavian civil" (values assigned to variable [LR.sub.2])."

Here are the summary table for groups assignments:

Now, the above suggests that Ireland has the lowest possible - "Insignificant Level" - of corporate disclosure rules compared to the OECD best practices standards. The results also show that Ireland does not belong to the group of highest disclosure-consistent legal regime (LR) that includes Common Law-type countries, but instead belongs to the lowest level of legal regime-consistent transparency.

28/8/2012: Debt- v Equity-led Funding and Systemic Crises

Apparently, there's been some serious movements in today's banks CDS, signaling some pressure building up in the system and potentially a disconnect between equity markets and bond markets. This wouldn't be the first time the two are mis-firing in an almost random fashion. In the longer-term, however, such episodes are very troubling for a good reason - long term imbalances build up in the two sources of capital funding is hard to unwind. It turns out, however, the difficulty of unwinding these is non-symmetric.

Last week's NBER Working Paper number 18329 (link here), titled "Debt- and Equity-led Capital Flow Episodes" by Kristin J. Forbes and Francis E. Warnock looked at "the episodes of extreme capital flow movements—surges, stops, flight, and retrenchment... [leading to] the question of":

• Which types of capital flows are driving the episodes and 
• If debt- ( bonds and banking flows) and equity-led (portfolio equity and FDI) episodes differ in material ways. 

"After identifying debt- and equity-led episodes, we find that most episodes of extreme capital flow movements around the world are debt-led and the factors associated with debt-led episodes are similar to the factors behind episodes identified with aggregate capital flow data. In contrast, equity-led episodes are less frequent, more idiosyncratic, and differ in nature from other episodes."

The study uses data on 50 emerging and developed countries starting with 1980 (at the earliest) and running through 2009.

The study found that "the vast majority of extreme capital flow episodes across our sample—80% 

of inflow episodes (surges and stops) and 70% of outflow episodes (flight and retrenchments)—are 
fueled by debt, not equity, flows."

After that, the paper develops analysis of "the factors that are associated with debt- and equity-led episodes of extreme capital flows. We follow the Forbes and Warnock (2012) analysis here by describing capital flow episodes as being driven by specific global factors, contagion, 

and/or domestic factors." 

The study found that: "to a first approximation equity-led episodes appear to be idiosyncratic, bearing 
little systematic relation to our explanatory variables. Notably, even the risk measures that were 
highlighted in Forbes and Warnock (2012) as being significantly related to extreme movements in 
aggregate capital flows have little or no significant relationship with equity-led episodes. In contrast, 
risk measures are important in explaining debt-led episodes; when risk aversion is high, debt-led surges 
are less likely and debt-led stops are more likely. Contagion, especially regional, is also important for 
debt-led episodes. Country-level variables are largely insignificant, except for domestic growth shocks; 
debt-led stops are more likely in countries experiencing a negative growth shock and debt-led surges are more likely in countries with a positive growth shock."

Perhaps in a warning to the policymakers currently embarking on financial repression path for dealing with the ongoing crises, "capital controls have little or no significance in  both equity-led and debt-led episodes, as also found in Forbes and Warnock (2012)."

Of course, we have to keep in mind that the current crisis is really a debt-led capital markets crisis, both at the corporate and sovereigns levels. And it is symmetric both for the US and Europe, where the main difference is not as much in equity vs debt financing, but in intermediated vs direct debt issuance.

28/8/2012: Challenging 'perpetual growth' hypothesis

Once in a while, there is a fascinating piece of thinking that focuses on the long-term economic trends that is worth reading. Robert J. Gordon's "Is the US Economic Growth Over? Faltering Innovation Confronts the Six Headwinds" (NBER working paper 18315 published last week - link here) is exactly that.

The study looks at an exceptionally complex issue of long-term (centuries-long) trends in growth from the point of questioning the basic premise of economics - the premise that future growth is a 'continuous process that will persist forever'.

Quoting from the paper, the author establishes the following basic points concerning the prospects for future growth (up to 50 years out from 2007 and abstracting from the fallout from the ongoing crisis):

1. "Since Solow’s seminal work in the 1950s, economic growth has been regarded as a continuous process that will persist forever.  But there was virtually no economic growth before 1750, suggesting that the rapid progress made over the past 250 years could well be a unique episode in human history rather than a guarantee of endless future advance at the same rate."
2. "The frontier established by the U.S. for output per capita, and the U. K. before it, gradually began to grow more rapidly after 1750, reached its fastest growth rate in the middle of the 20th century, and has slowed down since.  It is in the process of slowing down further."
3. "A useful organizing principle to understand the pace of growth since 1750 is the sequence of three industrial revolutions. The first (IR #1) with its main inventions between 1750 and 1830 created steam engines, cotton spinning, and railroads. The second (IR #2) was the most important, with its three central inventions of electricity, the internal combustion engine, and running water with indoor plumbing, in the relatively short interval of 1870 to 1900.  Both the first two revolutions required about 100 years for their full effects to percolate through the economy. During the two decades 1950-70 the benefits of the IR #2 were still transforming the economy, including air conditioning, home appliances, and the interstate highway system. After 1970 productivity growth slowed markedly, most plausibly because the main ideas of IR #2 had by and large been implemented by then."
4. "The computer and Internet revolution (IR #3) began around 1960 and reached its climax in the dot.com era of the late 1990s, but its main impact on productivity has withered away in the past eight years.  Many of the inventions that replaced tedious and repetitive clerical labor by computers happened a long time ago, in the 1970s and 1980s.  Invention since 2000 has centered on entertainment and communication devices that are smaller, smarter, and more capable, but do not fundamentally change labor productivity or the standard of living in the way that electric light, motor cars, or indoor plumbing changed it."
5. "... It is useful to think of the innovative process as a series of discrete inventions followed by incremental improvements which ultimately tap the full potential of the initial invention. For the first two industrial revolutions, the incremental follow-up process lasted at least 100 years. For the more recent IR #3, the follow-up process was much faster. Taking the inventions and their follow-up improvements together, many of these processes could happen only once. Notable examples are speed of travel, temperature of interior space, and urbanization itself."
6. "The benefits of ongoing innovation on the standard of living will not stop and will continue, albeit at a slower pace than in the past. But future growth will be held back from the potential fruits of innovation by six “headwinds” buffeting the U.S. economy, some of which are shared in common with other countries and others are uniquely American.  Future growth in real GDP per capita will be slower than in any extended period since the late 19th century, and growth in real consumption per capita for the bottom 99 percent of the income distribution will be even slower than that." 
7. "The headwinds [to growth] include the end of the “demographic dividend;” rising inequality; factor price equalization stemming from the interplay between globalization and the Internet; the twin educational problems of cost inflation in higher education and poor secondary student performance; the consequences of environmental regulations and taxes that will make growth harder to achieve than a century ago; and the overhang of consumer and government debt.  All of these problems were already evident in 2007, and it simplifies our thinking about long-run growth to pretend that the post-2007 crisis did not happen."

An interesting and highly illustrative chart plotting growth evolution:

And the conclusion? "A provocative “exercise in subtraction” suggests that future growth in consumption per capita for the bottom 99 percent of the income distribution could fall below 0.5 percent per year for an extended period of decades." Illustrated here:

27/8/2012: Second worst in GDP growth in Q1 2012?

When on July 12 the CSO published the latest Quarterly National Accounts, the Irish media and the Government were quick to focus on the positive side of the reported data - the revised figures for Q4 2011 that Irish GDP rose 1.4% in constant prices terms y/y in 2011 compared to 2010. Fr less attention was paid to a massive 2.5% y/y fall off in GNP and even less attention still was given to Q1 2012 preliminary estimates that showed q/q contractions in GDP of 1.1% and in GNP of 1.3%. All in, the headline figure referenced was almost always the up-beat "Irish economy grew at a euro area average rate in 2011".

Now, there are many caveats that should accompany q/q figures, including:

• Q/q changes can be volatile;
• Preliminary figures can be subject to significant revisions in the future; etc

Keeping all of this in mind, today's data release from the OECD is discomforting. Here's the chart:

As the chart above clearly shows, excluding Greece (missing data), we are the second worst performer (after Luxembourg) in terms of GDP growth in Q1 2012 in the entire OECD.

Let's hope those future revisions come in to the significant upside.

27/8/2012: Mid-Term Forecasts for Russian Ruble: Capital Economics

An interesting view on the Russian ruble medium term outlook was published in the ECR weekly monitor arguing that as USD/Euro moves to dollar strengthening, we can expect devaluation of the ruble vis dollar by ca 10% over the coming 18 months. Liza Ermolenko, economist with Capital Economics, provided three core reasons for devaluation:

1. Expected intensification of the euro area crisis will likely weigh on Russian exports just as the Central Bank of Russia (CBR) is reducing market interventions in support of ruble and is aiming to widen the currency band. Monetary conditions are expected to stay relatively stable, according to Ermolenko, as fiscal spending will also remain constrained.
2. Deterioration in Russia's balance of payments due to fast growth in imports, and possible fall in oil prices to USD85 pb by the end of 2012. Capital Economics projects Russia's current account surplus to fall to 3.5% of GDP in 2012 from 5.5% in 2011, with a possibility of posting a small deficit in 2014.
3. Long term competitiveness is deteriorating in Russia, as the economy gave up productivity and cost competitiveness gains of 2008-2009 crisis period to higher inflation. "Real exchange rate [linked to consumer prices] is now back to where it was in mid-2008", according to Ermolenko.

So Ermolenko forecasts 5% decline in the ruble against the euro/dollar basket by the end of 2012 and a similar decline in 2013, with most of the decline driven by devaluation against the USD. Target is Rb35.5/USD by end-2012 and Rb38.5/USD by end-2013 from current Rb31.9/USD. Euro forecasts are for slight devaluation to Rb39.0/Euro by end-2012 followed by appreciation to Rb38.5/Euro by end-2013, compared to Rb39.4/Euro current.