New Economist

Are emerging Asia’s reserves really too high?

Aside from China, no, according to a new IMF working paper by Marta Ruiz-Arranz and Milan Zavadjil. This is in large part an attempt to insure against a repeat of the 1997 Asian currency crisis:

The paper has presented evidence that to a large extent explains Asia’s large reserve accumulation since the 1997–98 crisis through the precautionary motive. Current reserve holdings in most of Asia (excluding China) are not seen excessive when compared with levels predicted by a simple model of optimal reserves applied to specific country and regional characteristics. By mitigating the potentially large welfare costs of crises, reserves provide benefits in terms of insurance that more than compensates economies for the
opportunity cost of holding liquid assets.

Large currency reserves have the added benefit of lowering borrowing costs:

Furthermore, the benefits of reserves in terms of reduced spreads on privately held external debt, and thus borrowing costs, further justifies most of the observed growth in reserves. The paper finds that a majority of economies in Asia continue to benefit from reduced spreads, as evidenced by the high estimated threshold levels beyond which no further gains are realized.

Nonethless, the authors consider that current reserves "are close to or have recently reached optimal
reserves levels", and "a slowdown in the pace of accumulation in Asia is now desirable."

China, meanwhile, remains an anomaly. These models "cannot fully explain the large stock of reserves in China" - a subject to be explored in future research.

Austan Goolsbee

The September/October 2008 edition of the MIT Technology Review has a feature by Mark Williams on Obama's senior economic advisor, Austan Goolsbee: Obama's Geek Economist No earth shattering insights, but another reminder of just how Chicago-ist an Obama presidency could be.

The credit crunch: what happened?

While Ken 'worst is yet to come' Rogoff is trying his level best to scare global financial markets about the credit crunch, research is now starting to filter through about just what happened last year. A new IMF working paper by Nathaniel Frank, Brenda González-Hermosillo and Heiko Hesse, Transmission of Liquidity Shocks: Evidence from the 2007 Subprime Crisis, does some of the spadework. As they explain, liquidity crisis soon segued into a solvency crisis (think Northern Rock, Bear Sterns):

It is found that the interaction between market and funding illiquidity increased sharply during the recent period of financial turbulence, and that bank solvency became important. ...What started out as a liquidity crisis, turned into a solvency issue.

It wasn't simply credit that dried up, it was trust - the whole basis of interbank money markets. Banks were unwilling to trust the disclosures or assurances of their counterparties. As a result central banks had to pump hundreds of billions into financial markets to address the liquidity spiral and to ensure the solvency of key financial institutions.

So why did these interactions and correlations spike when the sub-prime crisis hit?

The analysis presented here suggests that increasing financial integration and innovation can make market and funding liquidity pressures readily turn into issues of insolvency.

The easy answer would be to blame the quants and financial engineers. But the real culprit was greed, reinforced by the lousy risk management and lax prudential standards of most major banks (and their clients, many of whom bought products they did not understand). While the money kept rolling in the door, senior managers were quite happy to avert their eyes to the ever-mounting risks.

I was not surprised by the sub-prime crisis; it was an accident waiting to happen. But I didn't expect the credit crunch to have been protracted, particularly once central banks interviened with such gusto.

Rogoff is probably right to say that we are only about half-way through the crisis. But the key issue for me is not whether another major bank goes bust (some of them clearly deserve to). It is whether the risk of US recession is now receding (a U-shaped downturn), or whether we are instead facing a 'W'-shaped downturn, with another growth dip looming. So far my controversial call of no US recession this year has held up, and I still think I am odds on to be proved correct. But the outlook for 2009 has becoming bleaker; there are now too many uncertainties to rule out an eventual recession.

Back again

The very welcome return of Dave Altig's Macroblog last week has prompted me to consider posting again too.

Apologies for the protracted absence. My non-virtual life has been rather hectic in recent months. Now that things have settled down a little, I hope to return to semi-regular postings again.

It's good to be back.