Friday, June 17, 2011

Summer Vacation!

I'm leaving today for two weeks of (mostly) vacation with the kids, visiting family and friends in Europe. I will probably not be able to avoid keeping up with major developments in the Greek Debt Drama -- next week promises to be an eventful one -- so I may do a bit of posting here and there... but hopefully there won't be too much of that. (For both Greece's sake as well as, very selfishly, my own...) At any rate, more frequent posting will resume in July.


Is there anything olive oil can't do?

Olive oil 'helps prevent stroke'

Olive oil can help prevent strokes in people over 65, a study suggests. Researchers followed around 7,000 people aged 65 and over living in three French cities, for at least five years.

They found those who used a lot of olive oil in cooking or as a dressing or dip had a lower risk of stroke than those who never used it.

...Commenting on the study, published in Neurology, Sharlin Ahmed of the Stroke Association, said: "Olive oil has long been known to have potential health benefits.

"It is believed that it could protect against conditions such as high cholesterol, high blood pressure and heart disease and so it's promising to see that it could have a similar protective function against stroke.

US Bank Exposure to Greece, part 3

Tracy Alloway at the FT summarizes some of the push-back against the idea that US banks have substantial exposure to Greece:
Who’s selling Greek CDS, again

There appears to have been a massive amount of misunderstanding about recently published BIS statistics regarding US banks’ Greek exposures. The idea that US banks are on the hook for $32.7bn of CDS written on Greece was first expounded by the Street Light blog, then picked up by us (unfortunately), then spread to Fortune and onwards to markets. This week US bank stocks moved on the concern, apparently.

Anyway, the BIS statistics do not clearly lay out the amount of US banks’ Greek CDS exposure. Anyway, the BIS statistics do not clearly lay out the amount of US banks’ Greek CDS exposure...

If you want a summary version, here’s Nomura’s new banking analyst Glenn Schorr:

The U.S. banks and brokers sold off yesterday [Wednesday] over concerns around exposure to a potential Greek debt restructuring or default. The concern was driven by a BIS report published this month that shows that U.S. banks and brokers have written $32.7bn of credit guarantees (most likely CDS protection) on Greece. Unfortunately, this number is only half the story, as it shows gross protection written but does not show the net exposure of U.S. banks, meaning that any hedges or collateral that the U.S. banks may have in place is not being captured in this number. While there is definitely some Greek exposure in the U.S. system, we think net exposure at the large U.S. banks and brokers is a whole lot less than the $32.7bn.
While I agree that the BIS data does not tell us how much of the exposure is due to CDS contracts, I disagree that it can't be used to tell us the size of the US banking system's exposure to Greek debt. The whole point of the BIS statistics is to measure the ultimate risks that banks face, after all, and so they take great pains to ensure that the statistics reflect the net effective exposure faced by banks. As explained by the BIS in their guide to the international statistics (pdf):
The statistics mainly provide information on international financial claims of domestic bank head offices on a worldwide consolidated basis, ie including the exposures of own foreign offices but excluding inter-office positions. Currently they indicate the nature and extent of foreign claims of banks headquartered in 30 major financial centres. In contrast to the residence or balance of payments principle of the locational statistics, the reporting of consolidated positions offers a more useful measure of the total risk exposure of a reporting country’s banking system.

...Consolidated data based on the residence of the party ultimately responsible for the repayment of an obligation (ultimate risk basis) in addition to total claims based on the residence of the immediate borrower (contractual claims) are more compatible with information produced by banks’ own internal risk measurement systems and are considered a more appropriate measure of country risk exposure.
Regarding the specific question of whether the "guarantees" listed in the BIS data are net or gross exposures, the answer is more complicated than the one provided by the Nomura analyst above. This week I asked BIS for clarification on how they handle CDS data. The BIS has told me that when a bank writes a CDS contract selling default protection, the gross amount appears in the line "guarantees". So Schorr has that part of the story correct -- the guarantees are, in a sense, gross CDS exposures, because they are not offset by the protection purchased (if any) by the bank to hedge the risk it took by selling the protection.

However, that doesn't mean that the offsetting protection purchased by the bank is simply not counted. It will be counted either in the "derivatives contracts" line of the BIS statistics, or the "foreign claims" line of the BIS data. In either case, the protection purchased through ofsetting CDS contracts are counted in the BIS data, so that when you add together the direct + indirect exposures, you have netted out all countervailing CDS positions and have the final, true, net exposure faced by banks.

In other words, the BIS data does indeed represent true net exposure, and in the case of US banks that exposure is about $40 billion to Greece, on par with the exposure faced by banks in France and Germany. No, we don't know exactly how much of that takes the form of CDS contracts, but we do know that the exposure is there.

Recent Exchange Rate Trends

Exchange rates are on my mind this morning. Perhaps surprisingly, the euro has not been devastated recently by the high level of uncertainty regarding Greece. As evident in the chart below, the euro's value against the dollar has fluctuated rather choppily over the past two months in response to developments in the Greek Debt Drama... but there has been no sustained loss in value. In fact, it's not at all clear that a Greek default would devastate the euro; a high probability of default is already priced into exchange rates by now, so depending on how things happen (i.e. if it turns out not to be a complete disaster for the core European banks), it's possible to imagine currency investors feeling relieved that the event is finally over, causing the euro to strengthen.

Meanwhile, the picture also illustrates that the Japanese yen recovered very quickly from a short drop in March in the wake of the earthquake disaster, and since then has trended slowly higher (unsurprisingly). Disasters for an economy -- either real or financial -- are not always disasters for the economy's currency.

By the way, it turns out that the currency that wins the award for gaining the most strength so far this year is the Swiss Franc. I hope you haven't put off buying that watch you've been wanting, because if you get paid in dollars, it has already gotten 10% more expensive this year for you...

Wednesday, June 15, 2011

Greece at its Limit

Ryan Avent provides an excellent summary of recent developments in the Greek debt drama:
Unpleasant Greek options

TODAY has been nasty day for markets, those in Europe especially. Equities are off. The euro is falling against the dollar. And yields on the debt of euro-zone periphery governments are rising to new heights. The yield on 3-month Greek securities is now over 12%. Markets want nothing to do with Greece if they can help it.

European yields have spiked many times before, and each time European leaders have responded with a new bail-out package or other reassurances to prevent Greek panic from fueling a broader contagion... So where's this go-round's intervention? Well the trouble at the moment is that Europe's leaders can't agree on one...

...It's not an insoluble set of problems. But given the euro-zone's institutional weaknesses, it's not a walk in the park, either.
I would have used stronger language than Ryan did in that last sentence, but I agree with the sentiment: the EU has demonstrated that it simply does not have the necessary mechanisms and institutions to deal with a deeply difficult problem like this.

Meanwhile, the Greek economy has been shut down by a general strike, the government is scrambling to avoid a collapse in the face of possible revolt by its own members of parliament, and protesters have been fighting "running battles with the police" today in the streets of Athens. All of that means that it seems increasingly improbable that the Greek government will be able to actually implement the new austerity package that was forced upon it by the "Troika" (the EU, IMF, and ECB).

If the agreed-to austerity measures are not passed into law by the Greek government, what happens? That would essentially mean the end of Greece's voluntary cooperation with the "kicking the can down the road" strategy. And if Greece isn't cooperating, then it's really hard to see how the Troika will agree to extend additional loans to Greece. This act in the drama may finally, finally be drawing to a close.

Tuesday, June 14, 2011

Has the Bad Housing Market Reduced Labor Mobility?

Economists Colleen Donovan and Calvin Schnure have written an interesting new paper examining whether the fall in house prices since 2007 in the US -- which has left many home-owners owing more on their house than it is worth -- created a lock-in effect that depressed labor mobility.

This question has significance far beyond either the real estate market or the labor market, because there has been a persistent line of argument from some that the US's current unemployment problem is not the result of insufficient demand, but is instead a "structural" problem resulting from the inability of the US economy to properly match people with available jobs. A frequent explanation for why it suddenly became difficult to match people with jobs in 2008 is that underwater mortgages have locked people in to their houses, reducing labor mobility and making job-matching more difficult.

The evidence presented in this paper indicates that the fall in house prices has indeed caused a "lock-in" effect, but has not significantly impacted labor market efficiency. Here's the abstract:

The collapse of the housing boom led to an unprecedented number of homeowners who are “underwater”, that is, owe more on their mortgage than their homes are worth. These homeowners cannot move without incurring significant losses on their homes, possibly causing a “lock-in” effect reducing geographic mobility. This raises concerns that a reduction in labor market mobility may hamper the ability to move to accept employment in another geographic market, degrading labor market efficiency and contributing to higher structural unemployment.

This paper examines housing market turnover and finds significant evidence of a lock-in effect. The lock-in, however, results almost entirely from a decline in within-county moves. As local moves are generally within the same geographic job market, this decline is not likely to affect labor market matching. In contrast, moves out-of-state, which are more likely to be in response to new employment opportunities, show no decline, and in fact are higher in counties with greater house price declines. Housing market lock-in does not appear to have degraded the efficiency of the labor market and does not appear to have contributed to a higher unemployment rate.
This is a significant piece of evidence against the "structural unemployment" explanation for the US's high and persistent unemployment rate. Yes, labor market inefficiencies do certainly exist, and there are a variety of reasons why economies don't always perfectly match unemployed people with available jobs. But the underwater mortgage "lock-in" phenomenon that has been cited as the primary reason why the US's labor market suddenly got so much worse starting in 2008 simply does not match the evidence.

As a result, if we want to understand why unemployment has been so persistently high in the US since 2008, we have to look beyond "structural" or supply-side explanations. Once again, the far simpler explanation seems to better match the evidence: there's just not enough demand, so businesses aren't hiring, and people remain unemployed.

A New Era for the US-China Trade Deficit?

Inflation in China is, if not quite galloping, at least trotting along at a decent clip:
Inflation quickens in China, India; Beijing raises reserve ratios

BEIJING/MUMBAI, June 14 (Reuters) - Inflation in China and India accelerated in May, prompting Beijing to lift bank reserve requirements on Tuesday and keeping pressure on India to raise interest rates later this week even as Asia's two big growth engines show signs of slowing and recovery stalls elsewhere.

China's consumer price inflation hit a 34-month high of 5.5 percent, keeping inflation-fighting at the top of the agenda for Beijing, which sees little chance of the current slowdown from last year's 10 percent-plus growth turning into a hard landing.
Inflation in China has been an important contributor to the subtle but very significant change in the pattern of trade that we've seen between the US and China. For nearly 20 years, the story of the US's trade with China was a simple and predictable one: month after month, year after year, the US imported more from China. US exports to China also grew, but at a slower rate, and so the US's trade deficit with China grew steadily. That story had grown so monotonous that by the mid-2000s many people had stopped paying attention to it.

But over the past couple of years that pattern has been broken. The big difference is that now, US exports to China are starting to grow rapidly, while US imports from China are growing slowly at best. Since the start of 2008, US exports to China have risen by about 40%, while US imports have risen by only about 10%. Granted, US exports are rising from a much lower base than imports, so it will be a while before we see that change actually start to reduce the US's overall trade balance with China... but even so, the bilateral trade deficit (goods + services) has been roughly constant for almost four years now, as shown in the chart below.

This striking change is the result of two related forces: the strong growth of the Chinese economy (particularly relative to the anemic US economy), and the rise in Chinese prices. Higher inflation in China means that Chinese-made products are now less competitive than they were a few years ago, inhibiting US imports. And at the same time, Chinese inflation makes US-made goods and services look somewhat cheaper to Chinese consumers than they used to.

Since there's probably no reason to expect either the growth differential or the inflation differential between the US and China to reverse course any time soon, it's reasonable to expect these recent trends in US-China trade to continue. And if so, then I wouldn't be surprised if we may be near the all-time peak of the US-China trade deficit. Within a year or two the US-China trade balance could actually begin to show sustained (and not recession-driven) improvement. And wouldn't that be a striking change from what we're used to? We could be near the end of an era...

Monday, June 13, 2011

Indirect US Exposure to the Euro Debt Crisis, part 2

As last week's new BIS data showed, it appears that US banks indirectly have substantial exposure to the peripheral Euro-zone countries that are teetering on the edge of bankruptcy. Exactly what form that exposure takes is a bit uncertain, though it seems likely that much of it is in the form of credit default swaps (CDS) written by the US banks to provide insurance against default to the holders of bonds from Greece, Ireland, and Portugal.

But it's a bit frustrating not to have a clearer understanding of exactly what form this exposure takes. So I've been trying to see if there is any public information that can give us a hint about exactly how the big US banks have incurred such exposure.

Unfortunately, it's very difficult to get any good information about banks' derivatives exposures. The major US banks tend to downplay their exposure to the Euro debt crisis in their SEC filings. For example, in their 2010 10-K filing Bank of America wrote:
Certain European countries, including Greece, Ireland, Italy, Portugal and Spain, are currently experiencing varying degrees of financial stress. These countries have had certain credit ratings lowered by ratings services during 2010. Risks from the debt crisis in Europe could result in a disruption of the financial markets which could have a detrimental impact on the global economic recovery and sovereign and non-sovereign debt in these countries. The table below shows our direct sovereign and non-sovereign exposures, excluding consumer credit card exposure, in these countries at December 31, 2010. The total exposure to these countries was $15.8 billion at December 31, 2010 compared to $25.5 billion at December 31, 2009.
In fact, B of A's direct exposure to Greece is listed at only about $500 million. But note that that is their direct exposure. What we learned from the BIS data is that they also have indirect exposures, which probably arise primarily through their credit derivatives purchases and sales.

The following table summarizes all of the useful information I could gather about credit default derivative activities from the 2010 annual SEC filings of the six largest banks in the US. It's not much, and doesn't really answer our original question, so mainly this just confirms what we have no way of knowing which US banks are exposed to the Euro debt crisis or why.

Let me walk you through the figures in this table. The first line shows CDS contracts sold by each bank -- essentially how much insurance against default each bank sold to third parties. Note that some of that insurance was on non-investment grade assets (which would include Greece, of course). That's the second line.

Now, it's often the case that a bank doesn't want to have an open position on that contract -- in other words, it doesn't really want to make the bet that the underlying asset will remain sound. In those cases the banks purchase default insurance themselves on the same asset. The effect is that the bank is then just making money on the spreads and fees, but has nothing to gain or lose based on whether the underlying asset defaults.

If you subtract line 3 from line 1, then you have the net open positions taken by each bank on the credit default insurance it has written. That line is highlighted in the table above, because that tells us how active each bank has been in actually placing bets on default outcomes. No details are provided by the banks about where those exposures are, however, either geographically or by type of underlying asset.

Finally, the last line is also somewhat interesting, because it tells us how much income each bank earned from their trading in CDS as well as their betting (taking open positions) on default events. Obviously, if you do it right you can really make some good money in the CDS market -- over $9 billion in 2010 for B of A. Note that every month that goes by without a Greek default is great for the sellers of default insurance on Greek assets, so it could well be that some of these banks are making a killing right now on the default insurance they've sold.

What can we conclude from this? I can think of a few things.

1. Bank of America, Morgan Stanley, and Goldman Sachs are the most aggressive in terms of taking open positions on default outcomes. But we have absolutely no idea how much of those positions (if any) were with peripheral Euro assets. Also, while the last two firms don't break out income attributable to CDS activities (at least not that I could find), B of A made a huge portion of their profits in 2010 from them. (Note that Citi did not indicate how much of the CDS protection that they sold was covered by purchases of CDS insurance, so they may or may not be in that list as well.)

2. The aggregate CDS exposures of the big US banks are certainly large enough to be plausibly consistent with the BIS estimate of about $100 bn in indirect exposures to peripheral Europe. If you add up the highlighted numbers (and make a guess at Citi's position), it seems reasonable to guess that the total net open positions on CDS protection sold to third parties by the big US banks is between $1,500 and $2,000billion. Attributing $35 bn of that (about 2%) to Greece, which has certainly had one of the most active markets (proportionally) for CDS contracts over the past year, doesn't seem to be a stretch.

3. Banks do not have to provide much detail about the indirect credit exposures that they take on when they sell default insurance through the CDS market. We have incredibly scant information about the positions that US banks take through default insurance, and therefore no idea about how any individual bank will be affected by a Greek default.

4. It's hard to find any other potential exposures to Greece, Ireland, and Portugal in the banks' public filings, other than through CDS contracts. Combined with points 2 and 3 above, the process of elimination suggests to me that CDS contracts are indeed likely to be the source of the bulk of US banks' indirect exposures to a Euro-zone default.

Finally, a note about the risk this poses to the US banking system. The big US banks are well-capitalized now, and can fairly easily absorb losses of several billions of dollars in the event of a Greek default. But two serious concerns remain. First, I fear that this may have the potential consequence of exacerbating the flight to safety that will happen in the event of Greece's default; if you have no idea who is really going to be on the hook and ultimately liable for CDS payments, your best strategy may be to trust no one. I don't think that triggering post-traumatic flashbacks of the fall of 2008 is going to do good things to the market or the economy. Second, I wonder if there's a public relations disaster just lying in wait for the big US banks. After all, how will you feel (assuming you don't work on Wall Street) when you read the headline that Big Bank X lost money because it sold billions of dollars of credit default insurance while it was on taxpayer life-support? Rightly or wrongly, I'm guessing that Big Bank X will not be very popular for a while.

Saturday, June 11, 2011

Greece Endgame, pt. 2

Dear Troika,

It seems that you're starting to agree with me: it's probably inevitable at this point. There will be some sort of restructuring (i.e. default) on Greek debt. It may be "voluntary" (Vienna-style) at first, but at best the voluntary-ness of it won't last past the present (June) agreement, so in a few months we'll be facing the same situation except with the "voluntary" option no longer on the table.

If you're a member of the "Troika" and you accept that, then it's time to change your goals. Perhaps until now you've been mainly working to try to avoid Greek default. (Though that has not been entirely clear.) And since the possibility of default grew and we began entering the endgame, it certainly seems like your objective shifted to trying to get a relatively good bargaining position for the negotiations about how default would happen. But now it's probably time to focus on something else.

That 'something else' is the precedent that you will be setting for Portugal and Ireland. They are carefully and critically watching your actions vis-à-vis Greece, and will take their cues from what you decide there -- as will investors around the world. In other words, while Greece is probably lost, the details of exactly how you decide to retreat will have a big impact on how investors and governments in Portugal and Ireland act. Time to move on to the next battle.

Put another way: if you do this right, the crisis could end here. If you do it wrong, you can multiply the crisis by three.

Yours sincerely,


Friday, June 10, 2011

Contractionary Mania

The current bizaare mania for contractionary policies during a time of low inflation and economic weakness is not confined to the US, or to fiscal policy:
ECB signals eurozone interest rates are set to rise

The European Central Bank (ECB) has signalled that it will raise interest rates next month, from 1.25%.

Earlier on Thursday, the ECB kept rates unchanged for the second month in a row, after increasing them in April for the first time in almost two years. The central bank wants to raise rates again in July to curb inflation in some of the eurozone's 17 member states.
However, one really has to squint to see any signs of an inflation problem in Europe. Commodity prices around the world (particularly oil and some raw agricultural products) experienced a bump in prices between the fall of 2010 and spring of 2011. But that is really the only source of inflation the Euro area has experienced recently, as the ECB itself admits, writing in their most recent Monthly Bulletin (pdf):
The increase in inflation rates during the first four months of 2011 largely reflects higher commodity prices.
Excluding energy and raw food prices, the core rate of inflation remains in the neighborhood of 1.5% over the past 12 month, well below the Euro-zone's average inflation rate over the past decade. The following chart shows core inflation separately in Germany and in the rest of the core Euro-zone over the past decade.

Yet despite its acknowledgement that the recent rise in inflation is almost completely due to transitory factors (which began to reverse themselves in May), and without providing any reasoning for this statement, the ECB continued its discussion of inflation in the latest Monthly Bulletin by adding:
Looking ahead, inflation rates are likely to stay clearly above 2% over the coming months.
It's hard to see how this will happen, when core inflation is well under 2% (which is by far the better predictor of future inflation -- see this post by Paul Krugman for further details on that), this winter's rise in commodity prices (that the ECB itself admits is the primary cause of the current bulge in headline inflation) is over, and in fact commodity prices have recently begun experiencing deflation as their prices fall back somewhat.

It's mystifying.

Wednesday, June 08, 2011

Greek Endgame?

The key players in this drama are making it embarrassingly easy to imagine exactly how a Greek default could happen this summer.

The immediate concern has been whether and under what conditions the "Troika" -- the IMF, the ECB, and the EU Commission -- would agree to give the Greek government another dollop of money (€12 bn) in July. Last Friday, the Troika seemed to indicate that they had agreed in principle to go ahead and disburse the July tranche of funds. But nothing has been finalized yet (and probably won't be until EU finance ministers meet on June 20), and public disagreements within the Troika are growing louder every day.

Consider the current state of affairs, and what we know about the members of the Troika:

1. The IMF. They have a policy of not disbursing additional funds unless they are assured that the recipient country has solid prospects of being fully funded for at least 12 months. Greece does not have such prospects. Note that the IMF takes great institutional pride in the fact that its loans always get repaid, in part because it is willing to be hard-nosed enough to stop throwing good money after bad. So even though the IMF seemed to agree to the July tranche with last week's announcement, it seems quite possible that the IMF could still back out if the other two legs of the Troika don't come to a realistic agreement covering the next 12 months. And then, of course, they'll have another chance to play coy again in three months...

2. The ECB. They have threatened sturm und drang if there is any Greek restructuring (i.e. default). They've made it quite clear that they will allow the Greek banking system to collapse if restructuring happens -- which, I've argued previously, essentially means that they are saying that they will force Greece out of the eurozone if there's a restructuring. With that threat in hand, they have placed themselves squarely in the camp of the large banks and other creditors, which may not be surprising since the ECB is in fact Greece's largest creditor.

3. The EU. Naturally, the governments of the EU are worried about the political consequences of events in Greece. That explains this week's letter to the ECB from the German finance minister, Wolfgang Schaeuble, who wrote that the German government won't support the disbursement of additional funds for Greece without some restructuring. In essence, the German government has placed itself squarely in the camp of European taxpayers, who naturally don't want to have to bear the cost of the Greek default single-handedly (i.e. without getting the banks and other creditors to share in the pain). What leverage do they have? They can refuse to contribute more money to Greece, and that is the threat contained in Schaeuble's letter.

Given this information, I encourage you to take a short multiple choice quiz.

Question 1: Are the public positions of the members of the Troika more consistent with:
(a) Three parties trying to come to an agreement on how best to prevent Greece from defaulting.
(b) Three parties each looking out for their own interests, arguing over who is going to bear the costs of the Greek default, and using whatever leverage they have to improve their own outcome in the event of default.

I think you could make an argument that either answer could still (possibly) be the right one. However, the current situation does feel very much like a typical endgame in any bankruptcy, whether personal, corporate, or sovereign: at a certain point, the arguments stop being about how to prevent the bankruptcy, and start to be about how the pain will be distributed. To me, it's beginning to feel like we've reached that point.

Monday, June 06, 2011

Betting On the PIGs

The BIS today released some very interesting new data (pdf) on the exposure of various parties to debt issued by the PIGs (Portugal, Ireland, and Greece). There is a lot of good stuff in this data -- particularly what it tells us about who is betting which way on a default by one of the PIGs. Let me first make three observations.

Observation #1. Default Insurance Matters.
First, the BIS data very helpfully breaks exposures into two pieces: direct exposures, which basically means creditors who own bonds issued by one of the PIGs; and indirect exposures, which for the most part means agents who sold default insurance to creditors, primarily through credit default swaps. As summarized in the following table, it seems that approximately 30% of total potential exposures to debt from the PIGs are covered by default insurance (see the figures in red). Put another way, if one of the PIGs defaults, creditors who actually hold bonds from that country will absorb about 70% of the losses, while agents (primarily banks and insurance companies) that sold insurance against the possibility of default will have to cover the remaining 30%. That's not a trivial amount. (All figures below are in billions of USD, as of the end of 2010.)

Observation #2. Direct Exposure in Europe, Indirect in the US.
The table above also hints at striking differences between how European and US creditors would be hit in the case of default by one of the PIGs. If Greece were to default, for example, approximately 94% of the direct losses would fall on European creditors, and only 5% would fall on US creditors. However, US banks and insurance companies would have to make about 56% of the default insurance payouts triggered by such an event, while European agents would make only 43% of those payouts.

The next table illustrates this difference even more starkly. In the case of Greece and Portugal, the vast majority of the losses that would be borne by creditors in Europe would be direct losses. In fact, French and German creditors would almost certainly be substantial net recipients of default insurance payments. (That's less clear in the case of Ireland.) Meanwhile, US financial institutions would have to make substantial net default insurance payments, which would account for between 80% and 90% of all losses borne by the US in the case of default (see the figures in red below).

Observation #3. Similar Overall Exposures in Europe and the US.
Finally, it's worth noting that once you account for the substantial payouts that US agents will have to make to European creditors in the case of a default by one of the PIGs, financial institutions in the US have roughly as much to lose from default as those in France and Germany. (See the figures in blue in the table above.) The apparent eagerness of US banks and insurance companies to sell default insurance to European creditors means that they will now have to substantially share in the pain inflicted by a PIG default.

This has some important implications. First, US and European financial institutions are likely to have very different incentives as negotiations regarding debt restructuring and reprofiling proceed. US banks and insurance companies are surely delighted with the "soft restructuring" that is currently being discussed. Such a partial default would probably not trigger default insurance payments, and so the pain would be borne almost exclusively by European institutions. On the other hand, some time soon it seems likely that European creditors will begin to prefer a "hard restructuring" that would require default insurance payouts from the US institutions that sold such insurance. Given how strikingly one-sided the net default insurance payments will be (from the US to Europe), it's easy to imagine how that could shape future negotiations over debt relief for the PIGs.

Second, there's an interesting puzzle here. Why have European and American financial institutions behaved so differently when it comes to the PIGs? Specifically, why have American firms been so willing to sell default insurance to the Europeans, though they have not bought much PIG debt? And conversely, why have the Europeans systematically been so eager to buy insurance for their PIG debt, even at the very high price such insurance now commands? In essence, European firms have been betting that a PIG default will happen sooner rather than later, while US firms have been betting that default would happen later or not at all.

There may be some subtle institutional reason for the dramatic difference in behavior between US and European financial institutions; I would welcome any insights or suggestions. An alternative explanation could be that there are informational differences, and/or that European financial institutions have a systematically different view of the PIGs than US financial institutions do. Could the Europeans know something that the Americans don't about the likelihood or timing of eventual default? I hesitate to believe that, but I don't have another good explanation for the one-sidedness of the betting on a PIG default...

UPDATE (June 13):
In response to questions from a number of readers, here are some details about BIS definitions.

First note that these exposures are net, not gross exposures. Here's the BIS definition of exposures on a consolidated basis as reported in this data: "The consolidated banking statistics report banks’ on-balance sheet financial claims (ie contractual lending) vis-à-vis the rest of the world and provide a measure of the risk exposures of lenders’ national banking systems. The data cover contractual (immediate borrower) and ultimate risk lending by the head office and all its branches and subsidiaries on a worldwide consolidated basis, net of inter-office accounts... [T]o reflect the fact that banks’ country risk exposure can differ substantially from that of contractual lending due to the use of risk mitigants such as guarantees and collateral, reporting countries provide information on claims on an ultimate risk basis (i.e. contractual claims net of guarantees and collateral) since June 1999." (BIS Quarterly Review, Statistical Annex (pdf), p. A4.)

Second, there's some confusion about whether what I've labeled "indirect exposures" are really comprised significantly of credit default swaps (CDS). The confusion arises from the fact that the BIS data contains a line entry for "credit derivatives" which is very small for US banks (a net exposure of about $1bn for US banks with respect to Greece in that category), but then also has an entry call "guarantees" that is much larger (about $33bn for US banks with respect to Greece). It turns out that most CDS contracts are actually probably included in the "guarantees" line of the BIS data, not the "credit derivatives" line.

Here's the explanation from the BIS guide to their international statistics (pdf, p.14):
[C]redit derivatives, such as credit default swaps and total return swaps, are only reported under the item 'Derivative contracts' if they are held for trading by a protection-buying reporting bank. Credit derivatives that are not held for trading are reported as 'Risk transfers' by the protection buyer and all credit derivatives should be reported as 'Guarantees' by the protection seller.

'Guarantees' are contingent liabilities arising from an irrevocable obligation to pay a third-party beneficiary when a client fails to perform some contractual obligation. They include secured, bid and performance bonds, warranties and indemnities, confirmed documentary credits, irrevocable and standby letters of credit, acceptances and endorsements. Guarantees also include the contingent liabilities of the protection seller of credit derivative contracts.
While we can't say for certain how much of US banks' indirect exposures to Greece are the result of CDS protection written on Greek bonds, we can say that any time a bank uses a CDS to take an open position rather than strictly for trading purposes (in which case we wouldn't expect the bank to have a significant open position by the end of the year anyway, which explains why the BIS entry for "credit derivatives" is so small), then that amount will show up in the BIS line called "guarantees". Given my suspicion that US banks are not writing a lot of letters of credit or otherwise directly issuing warranties and endoresements to Greek institutions, it seems likely that the bulk of the indirect exposure reported by the BIS for US banks to Greece is in fact in the form of CDS contracts.

UPDATE #2 (June 13): For more on this, see the new post Indirect US Exposure to the Euro Debt Crisis, part 2.

Sunday, June 05, 2011

QE2: What it Did, and What it Didn't Do

QE2 is winding down, and will be completely finished sometime around the end of this month. And as I mentioned yesterday, I think that the chances for a new round of expansionary action by the Fed this year are very small. Despite what some think, however, the reason for that is not because the Fed's last effort -- what is usually, if inaccurately, referred to as "QE2" -- was a failure. In fact, the research indicates that QE2 worked as intended, and had positive, if modest, effects on the US economy.

What's in a name

Let's start by clearing up an oft-misunderstood point. The Fed did not actually engage in what we typically think of as "quantitative easing", the way that the Bank of Japan did during the early 2000s. The goal of the Large Scale Asset Purchase ("LSAP") program (the more accurate term for QE2) was never to "create money". As illustrated in the chart to the right, none of the reserves given by the Fed to banks under LSAP were actually lent out -- they were all simply held by banks as additional excess reserves, exactly as the Fed expected and intended. Since "money" is only created when banks lend out their reserves, this means that the LSAP program didn't cause any money to be created, which is why the supply of money didn't budge.(1)

So "QE2" (I'll revert to the common shorthand for convenience) was not intended to create money, and did not create money. Instead, the program was intended to help the recovery by reducing long-term interest rates. The Fed did that by selling short-term assets and buying long-term bonds -- that's really the essence of LSAP. (Since the Fed doesn't normally buy a lot of long-term bonds, this program was new and got a special name, but it's fundamentally quite a simple idea.) And the hope was that by buying some long-term bonds and thereby lowering long term interest rates, QE2 would help stimulate demand.(2)

What QE2 didn't do

Before we examine what QE2 did do, it's helpful to understand what it didn't do. A lot of the evils of the world have been wrongly attributed to QE2 in recent months. Here are some frequent criticisms:
  1. QE2 has caused rampant inflation.
  2. QE2 has artificially inflated asset prices such as the stock market.
  3. QE2 has devalued the dollar.
  4. QE2 simply didn't work.
Let's take these in turn.

1. Inflation: Critics say that all of the money pumped into the economy by QE2 has caused a surge in prices. Yet we know that QE2 has actually not created any additional money. So it's hard to see how QE2 has caused inflation. Furthermore, it's quite straightforward to trace the recent rise in global food and commodity prices to certain specific factors such as turmoil in the Middle East and several bad harvests for grains and vegetables (Russia, Argentina, Australia, Mexico).

2. Asset prices: Critics say that by purchasing long-term assets, the Fed has flooded the financial markets with cash, causing all asset prices to rise. A more sophisticated variant of this criticism is that by driving long-term interest rates down, QE2 has forced investors to seek higher returns in other types of assets, driving their prices up. But there are several problems with this theory. First, QE2 created no money (not to beat a dead horse or anything), so any notion that there was a broad injection of liquidity that caused commodity price inflation is wrong. Second, many of these same critics say that QE2 hasn't worked (point 4), and they point to the fact that long-term interest rates are no lower now than they were in the fall of 2010. But if interest rates weren't driven down, how could QE2 have caused asset prices to rise? (As shown below, the evidence is that interest rates actually did go down in response to QE2, but that is not generally recognized by QE2's critics.) Finally, the Fed has only purchased $600bn in long-term US government bonds. That's less than 5% of the US government bonds in existence, and probably well under 1% of the value of all types of traded assets (stocks, bonds, commodities, real estate). Even though the evidence (see below) is that QE2 was able to push down interest rates a bit, it doesn't seem likely that such a relatively tiny influx of demand into bond markets could cause a dramatic change in overall asset prices outside of the bond market.

3. The value of the dollar: Critics say that QE2 weakened the dollar by causing inflation and/or by causing a loss of confidence in the dollar. But the dollar is just as strong as it was in the middle of 2008, and only about 3% weaker than it was in Oct 2010 when QE2 started. So no systematic weakening of the dollar is apparent, which makes it unclear why the critics of QE2 raise this complaint, since they do not typically make the correct comparison against what the dollar exchange rate would have been in the absence of QE2. But more importantly, even if QE2 has caused the dollar to be weaker than it would otherwise have been, we should be thankful for that -- a weaker dollar is exactly what the US economy needs right now to help stimulate demand. It would be a good thing right now, not a bad thing.

4. QE2 simply didn't work: Some critics say that it was a waste of money -- it cost $600 billion but the economy is still lousy. First of all, QE2 didn't actually cost anything -- the Fed still has that $600bn, it's just now in the form of US government bonds. But second, yes, I agree, the economy IS still lousy... but that doesn't tell us anything about whether QE2 worked. Without QE2, it's entirely possible that the economy could have been in even worse shape. So the correct comparison to understand the effects of QE2 is to try to understand what would have happened in the absence of QE2. This, the critics of QE2 do not do. (Plus, if you think that QE2 didn't have any effects, then you should really drop criticisms 1-3, which rely on the premise that QE2 was effective.)

In short, it's pretty unlikely that QE2 caused any of the terrible things its critics attribute to it. So did QE2 actually accomplish anything?

What QE2 did do

The correct way to figure out what QE2 did is to first try to estimate what would have happened without QE2, and then compare that with what actually did happen. And while that can be a tricky exercise, that's what economic research is all about, so let's see what the research has found.

  • Krishnamurthy and Vissing-Jorgensen (Kellogg Northwestern): "The Effects of QE2 on Long-term Interest Rates" (pdf). They find that QE2 was likely to reduce interest rate on long-term AAA bonds by about 30 basis points, and rates on average long-term corporate bonds and mortgage loans by about 10 basis points, compared to what they would otherwise have been. They do not estimate what impact, if any, those interest changes had on real economic activity.

  • Gagnon, Raskin, Remache, and Sack (New York Fed): "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" (pdf). Using two completely different methodologies they find that QE1 (which was about 3 times the size of QE2) reduced long-term interest rates by between 50 and 80 basis points. Based on that estimate, the implied effect of QE2 would be to reduce long-term interest rates by between roughly 15 and 30 basis points.

  • Hamilton and Wu (UCSD / Chicago): "The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment" (pdf). They estimate that a $400bn LSAP by the Fed would reduce long-term interest rates by about 13 basis points; a simple linear extrapolation of this result implies that QE2 would have reduced interest rates by about 20 basis points.

  • D'Amico and King (FRB): "Flow and Stock Effects of Large-Scale Treasury Purchases" (pdf). They look at the stock and flow effects of the Fed's purchases of Treasury securities in 2009 to estimate their impact on interest rates. Their estimates imply that QE2 would have had a total impact on long-term interest rates of between 15 and 30 basis points.

  • Chung, Laforte, Reifschneider, and Williams (FRB / SF Fed): "Estimating the Macroeconomic Effects of the Fed's Asset Purchases". Using the Fed's own large-scale model of the US economy (FRB/US), they estimate that QE2 pushed down long-term interest rates by about 25 basis points. They also use the FRB/US model to estimate the impact that this had on unemployment and output, and find that QE2 raised GDP by about 0.75%, and employment by about 700,000.
While this is not an exhaustive compilation of the research, it's striking that the estimates are all remarkably similar, despite very different methodologies: QE2 reduced long-term interest rates by 20 to 30 basis points compared to what they would otherwise have been, and this in turn almost certainly had some positive impact on employment and output in the US.

So... Was QE2 a good idea?

Unfortunately, QE2 is not the only thing that has affected the US economy over the past 6 months, and many of the other forces at work have negatively impacted the economy. So the small but positive effects of QE2 were swamped by the other things going on such as supply-side shocks, contractionary fiscal policies, the US Treasury's program of large scale asset sales (i.e. bond sales to finance the deficit) that directly undid much of the effect of QE2 on interest rates (see Jim Hamilton for more on that), and a discouraging lack of private demand.

So yes, I would say that QE2 was probably a good idea, but it was simply not a sufficiently powerful tool to be able to single-handedly ensure a good recovery in the face of all of these headwinds. It helped a bit at the margin, and may have played a crucial role in helping the US step away from a dangerous flirtation with deflation in 2010... but the problems facing the US economy are just too numerous and substantial. My conclusion is that the only policy tool powerful enough to really help the US economy right now would be a new round of expansionary fiscal policy. Unfortunately, that's about as likely as me winning an Oscar this year.

That doesn't mean that QE3 would be a bad idea. In fact, given the new and alarming weakness in the US recovery, I think that further expansionary monetary policy would be very much worth trying. I wouldn't expect a dramatic impact, but right now the US could use every little bit of help it could get. Unfortunately, QE3 is only slightly less unlikely than a new round of expansionary fiscal policy (maybe on par with the likelihood of me winning a Grammy). And that's too bad, because every month that goes by with current levels of unemployment causes permanent long-term damage to countless individual lives, as well as to the US economy as a whole.

UPDATE: text edited slightly for clarity.

(1) For more on the distinction between what the Fed actually did and "quantitative easing", take a look at this speech by Ben Bernanke from January 2009, especially the part about halfway through.
(2) There are a number of channels through which lower long-term interest rates could possibly stimulate demand, including wealth or
portfolio effects, exchange rate effects, and direct interest rate effects.

Friday, June 03, 2011

Missing the Will to Fight

Gavyn Davies wonders where we can look for help as the US economy struggles to regain some forward momentum:
US economy: out of ammo?

The US employment numbers for May seemed to surprise the markets, but in fact they confirmed what we already knew from a string of earlier data releases, which is that the economy has slowed very markedly in recent months. The debate now is whether this slowdown has been triggered mainly by transitory factors – the fallout from the Japanese earthquake, stormy weather, and a spike in gasoline prices above $4/gallon – or whether it reflects a more fundamental malaise in the economic recovery.

...I am not usually disposed towards pessimistic nightmares about the US economy, but I am worried about the all-too-easy assumption, which is often heard from investors, that the Fed will automatically ride to the rescue if there are signs of a double dip recession. In fact, I have been told several times this week that QE3 is already a “done deal”...

...The Fed itself has done many studies which show that QE has had very similar effects to more conventional forms of monetary easing, but the evidence of the past 6 months has made many people sceptical about this comforting conclusion. Since QE2 was launched, real GDP growth has slowed markedly, while inflation and commodity prices have risen. Rightly or wrongly, another dose of the same medicine would certainly be a hard political sell.

And that is the source of my nightmare. If the present downward momentum in the economy were (unexpectedly) to continue, where would the rescue come from? With the Republicans in charge of the House, another fiscal stimulus seems improbable, to say the least. And even Mr Bernanke, who is clearly able to read the political tea leaves, has said that the hurdle to more Fed easing is “very high”. In these circumstances, the markets might suddenly conclude that the US cavalry is “out of ammo”.
Davies is right to worry. While transitory factors have played a role in the spring slowdown in the US economy, they only account for a portion of the problem. And unfortunately, I really don't think we can expect any new expansionary fiscal or monetary policy this year.

I would disagree with him about one crucial point, however: the reason that QE3 won't be tried this year is not, as Davies suggests, because QE2 proved ineffective. Rather, QE3 is simply not politically feasible for the Fed under present circumstances. Conservatives have attacked the Fed's program of Large Scale Asset Purchases (LSAP) not because they have actual evidence about its effects -- they don't -- but rather because they find it a convenient shorthand for criticising current macroeconomic policy in the US. Given fierce Republican opposition to expansionary policies, and in the context of the various threats they have made to curb the Fed's independence, Bernanke's hands are effectively tied this year.

So let's be perfectly clear about why policy-makers aren't fighting to save the recovery. It's not because they are out of ammo, or because the remaining rounds in their holster are defective. It's because the political will to fight for the US economy is simply not there.

Contractionary Fiscal Policy and the US Job Market

The BLS released its estimates of employment and the unemployment rate for May. Unsurprisingly, it was a weak report, showing a marked slowdown in the US's net job creation in the private sector in May compared to preceding months.

The government sector of the economy continued to make the jobs picture worse. May was the seventh month in a row during which government layoffs undid some of the work of the private sector in creating jobs. Since January 2009, government employment has shrunk in 21 of 29 months -- and without temporary hiring for the Census, it would probably have shrunk in 25 of the last 29 months.

This steady reduction in government employment is a form of contractionary fiscal policy. (Note that most of the layoffs are at the state and local level, and thus are primarily composed of teachers and public safety personnel.) If government employment were simply keeping up with population growth in the US, we would expect to see about 17 to 18 thousand more state and local government jobs each month. Instead employment has shrunk by an average of 15 thousand jobs per month since the start of 2009.

The following chart shows what the monthly employment report would have looked like over the past 8 months (i.e. since the one-time effects of the Census that skewed employment from March-Sept of 2010) if government employment had simply kept up with the rate of population growth:

And total employment in the US would have followed the blue line in the chart below, rather than the red line:

In other words, in the absence of the sharp cutbacks in government spending that have been prevalent in the US over the past year or two, about 1.3 million additional people would be working now compared to 8 months ago, rather than the actual job growth we've experienced over that time of about 1 million - a 30% difference. That's a pretty tough headwind to fight, especially for an economy that's already struggling.

Thursday, June 02, 2011

The Beatings Will Continue Until Morale Improves*

Greece readies itself for a new round at the whipping post:
Greece to present new austerity plan

(Reuters) - Greece intends to present a fresh austerity plan on Friday, a government official said, after Moody's cut its credit rating deep into junk territory and said there was an even chance of eventual default.

The budget plan will include a faster pace of privatisation and 6.4 billion euros ($9.2 billion) of new savings, including some tax rises, to eat into Greece's debt mountain, the senior official told Reuters.
As Joseph Cotterill points out at Alphaville, the problem is that Greece continues to miss targets set last year for raising additional revenue. And so the vicious cycle of contractionary fiscal policies leading to lower income leading to lower tax revenues leading to additional contractionary measures continues...

* For those that are curious, the original source for this oft-repeated quip is not known, though some attribute it to facetious elements in the Japanese Imperial Navy during the Second World War.

Wednesday, June 01, 2011

Supply-Side Factors and the Soft Patch

It seems to be official; while those immersed in the data have been noting ominous signs about the strength of the US's economic recovery for a couple of months, the business press has now grabbed onto the theme wholeheartedly:
The weakness in the US economy over the past few months has been disappointing, to say the least. But I've been wondering whether it's possible that the palpable slowdown in growth could be directly the result of two potentially significant events that have certainly had a negative impact on the US economy in recent months: the sharp rise in oil prices, and the earthquake in Japan. Could this spring's sudden slowdown in the US economy simply be due to these suppply-side shocks?

So I did a little back-of-the-envelope estimation to see whether we can explain the "soft patch" as simply the result of expensive oil and horrible earthquakes. The table below shows my calculations. I make a couple of assumptions to arrive at these estimates. First, I use as a rule-of-thumb the formulation that a $10/bbl increase in the price of oil translates into a roughly 0.3% fall in GDP over the course of a year. (That figure is based on a number of discussions about the impact of the price of oil on the US economy, including by Dean Baker and Roubini and Setser (pdf).)

Second, I construct an estimate of the impact of the earthquake in Japan on manufacturing output in the US, based in part on some of the narrative accompanying the Fed's most recent release of Industrial Production data, which specifically noted how earthquake disruption significantly impacted US auto production in April. Third, I assume that US exports to Japan fell as Japan's economy slowed sharply in the wake of the earthquake. (Note that I also assume that both of these effects will be slighly reversed in future months.)

The results are not trivial, but neither are they as large as I had hoped, to be honest. The calculation above suggests that these two effects reduced payroll employment by perhaps 70 thousand in both April and May. The negative impact on GDP growth was likely only around 0.2% in Q1( from the headline annualized rate), though it may be closer to 0.5% in Q2.

So unfortunately, these effects are simply not large enough to completely account for all of the slowdown in economic activity in the US in recent months. They certainly haven't been helping things, and are responsible for some part of the soft patch we're in... but it also seems that there must be some demand-side contributors as well. And that's the worrying part, because while the negative supply-side factors may reverse themselves in coming months on their own, it's considerably more difficult to imagine where a new boost to demand is going to come from.

Falling House Prices and Jobs, Jobs, Jobs

Yes, the decline in house prices continues. The Case-Shiller index of house prices for March 2011 was released yesterday, and confirmed that prices in many major markets in the US continue to fall. The average of house price indexes for the 20 largest cities in the US looks like this:

There is some variation in how local markets are doing, however. A few cities like Washington DC and Boston have seen house prices increase a bit over the past year, while in others the decline in prices continues as a rapid rate. Part of the explanation is that there are differences in how local and regional economies are doing.

The table at right compares the change in house prices against the local unemployment rate for a group of major US cities. In general, cities with lower unemployment rates in 2010 tended to have better-performing housing markets. A notable exception to that general correlation are the cities in California; for some reason, despite very high unemployment in California, housing prices seem to have remained roughly stable there in 2010. But overall, it's not at all surprising that regions and cities that had better job markets in 2010 tended to also have better real estate markets.

It's worth remembering that the bear market in houses probably still has a few years left to go. The real estate market is notoriously cyclical, and those cycles typically seem to be around 14 to 18 years long from peak to peak in the US. During the last bear market in residential real estate during the 1990s, it took about 8 or 9 years for prices to bottom out, as illustrated by this chart:

So based on historical experience, it will probably be another 3 to 5 years before house prices begin to pick up in a meaningful way in the US. But if we could get stronger economic growth and reductions in unemployment in the US, that would surely help to prevent further price declines in real estate. And that in turn would help to wind down the vicious cycle of underwater mortgages, foreclosures, and continued declines in house prices. It's yet another reason that the focus of policy-makers should be on jobs, jobs, jobs.