New Economist

Prediction market summit

Though I won't be anywhere near San Francisco tomorrow, I'd like to have attended the first Predictions Market Summit. It looks fascinating. (Hat tip: Stephen Kirchner).

How should central banks communicate?

The Federal Reserve Board is more effective at shaping market expectations than the European Central Bank. How come? New ECB working paper no. 557 by Michael Ehrmann and Marcel Fratzscher, How should central banks communicate? (PDF) finds that diversity can sometimes help - but may also be a hindrance:

Comparing communication policies by the Federal Reserve, the Bank of England and the ECB since 1999, we find that communicating the diversity of views among committee members about monetary policy lowers the market’s ability to anticipate policy decisions as well as the future path of interest rates. This effect is sizeable, accounting for instance for one third to half of the prediction errors of FOMC policy decisions.

By contrast, individualistic communication regarding the economic outlook is found to be beneficial for the Federal Reserve, enabling market participants to better anticipate the future path of interest rates. Thus, it is the collegiality of views on monetary policy but the diversity of views on the economic outlook that enhance the effectiveness of central bank communication.

I accept these points so far as they go, but surely there are other factors at play - greater heterogeneity, in particular? One would expect the 12 members of the ECB Governing Council who are governors of national central banks to come from a wider range of monetary policy traditions and practices, and to represent a greater divergence in economic conditions, than those on the Federal Open Market Committee. That, plus the 'newbie' status of the ECB - and a high degree of political lobbying and pressure - surely helps explain why the ECB has often times sent quite a confused messages to markets. This was especially the case in its first three or four years of operation.

Dickens was right

The novels of Charles Dickens are replete with dodgy characters. So what has changed in 150 years? Not that much. Norwich Union report that the cost of fraud to the nation rose to nearly £16bn last year, or £650 per household. The BBC story gives an example of the inventive nature of these latter day rogues:

The link between fraud and organised crime is revealed by the example of a drugs gang in a big English city. The criminals have contrived hundreds of car accidents in which they lured members of the public to crash into the gang's cars.

"The scale of this operation is enormous," Chris Hill said. "This gang had induced more than 400 accidents in the course of a year.

Meanwhile The Register reports the UK 'full of fraudsters', with nearly half of people quizzed in a survey admitting to forgery and one in ten to low level identity fraud.

A quarter of 1,000 Britons polled in a survey by document and identity verification firm TSSI confessed to exaggerating their educational qualifications to gain employment. One in ten of those quizzed by TSSI admitted they had misused ID or access control systems by impersonating someone else or had assisted someone else to do so, while a third (32 per cent) admitted conning their way past security personnel. One in five (21 per cent) owned up to having used fake identity cards.

"Identity fraud is now a major risk to consumers, yet our study shows that low level identity abuse and fraud is commonplace to the extent that it is almost becoming socially acceptable," said Danny Chapchal, TSSI's executive chairman.

Nearly half (45 per cent) of Brits polled in the survey admitted to some kind of forgery. ID cards were by far the most popular item, with 18 per cent admitting to forging these. Other items included doctors notes (five per cent); fake letters on company letterhead (four per cent); reference letters (four per cent); travel tickets (two per cent); concert tickets (one per cent); and tickets for sporting events (one per cent).

Just over one in ten people (12 per cent) owned up to impersonating someone else over email. Seven per cent confessed to assuming another person’s identity through forging their signature on letters or cheques. Meanwhile one in seven (14 per cent) confessed to spying on people entering PINs, pass codes and passwords.

A nation of swindlers, con artists, fraudsters and charlatans? You bet. Dickens was right.

The Register points out, as I should, that TSSI's Dishonest Britain report (which can be downloaded here) is self interested. 

TSSI has a vested interest here, of course, in talking up the scope of the very dishonesty among the general public its technology is designed to addresses. Nonetheless we can't help but be impressed by the ability of its researchers to elicit admissions from random punters in train stations that might (were they not anonymous) result in an extended stay at Her Majesty's pleasure.

Avian flu economics 5: What should investors do?

You know an issue has hit the mainstream when newspapers and magazine start offering investment advice about it. Yesterday's Observer  had an anonymous article, Bird flu: if symptoms persist, consult your stockbroker... , which contained these pearls of wisdom:

Research from the global portfolio strategists at giant American finance house Citigroup sums it up in a nutshell - sell British Airways and BP, buy Blockbuster and Nintendo. The lesson is that in the case of a serious outbreak, we will be too frightened to leave our homes.

The research paints a bleak economic analysis of the possible situations the world faces if the virus makes the leap from birds to humans. The worst case scenario - if the H5N1 virus becomes transmissable between humans - leads to slower global growth, rising risk aversion, declining interest rates and 'significant wealth effects'.

If the world suffers a virulent pandemic similar to the Spanish flu of 1918 which killed up to 50 million people, you should sell airlines, hotels and luxury goods companies, as well as oil, travel and hospitality companies.

On the other hand, the best case scenario leads to a temporary blip - the markets hate uncertainty - but this is, in fact, a buying opportunity, just as happened during the Asian Sars crisis three years ago. Buy telecoms, internet and, of course, drugs companies. 'While it is difficult to quantify the likelihood of a human pandemic, our analysis suggests avian flu is a rising risk to the global economic outlook,' says the report.

Crass? Certainly. Insensitive. Of course. (Now you know why the article was anonymous).

Despite its headline, Prevent A Pandemic, Make A Profit, Business Week's article is a little less exuberant, noting that "even a disaster such as a global flu pandemic will make someone richer":

Where there's disaster, there's opportunity for business. Consultants such as Booz Allen Hamilton Inc. and Kroll Inc. are already selling advice to business and governments on flu preparedness. Companies are stocking up on items thought to slow the spread of disease such as masks and hand sanitizers -- potential sales for companies like Beijing-based Kimberly-Clark (China) Investment Co. President Stephen Shao says his company is already developing new lines of medical masks, wipes, and hand-washing liquids.

Public health officials say that with the right early warning systems, they could spot a dangerous flu strain soon enough to snuff it out. The pot of gold: $1 billion-plus that countries have proposed to spend on enhancing global biohazard surveillance. Enter Applied Biosystems, the company that made the advanced sequencers that deciphered the human genome...

Foreign exchange intervention: What do we now know?

The Federal Reserve Bank of St. Louis Review, November/December 2005 issue contains a sceptical survey by Christopher J. Neely of exchange rate intervention. An Analysis of Recent Studies of the Effect of Foreign Exchange Intervention (PDF, see also Data.txt) provides a "selective review" of the empirical literature on the effect of foreign exchange intervention, focussing on high-frequency data or event studies.

...this paper has argued that even nonparametric event studies are still subject to all the econometric problems that beset more conventional econometric procedures. An examination of simultaneity in a nonparametric event study illustrated this point. Event studies will correctly infer the structural effects of intervention only under fairly strong conditions.

Recognition of the assumptions explicit in and analysis of the limitations of the procedures are not criticisms of intervention studies. Rather, explicit identification of drawbacks enables researchers to assess results more realistically and improve their procedures.

With respect to structural studies, this paper shows that the effects of intervention in Kim’s (2003) rich macroeconomic model are not identified and cautions that the innovative work of Kearns and Rigobon (2005) is potentially subject to the Lucas critique.

Finally, the paper argues that the nonlinearity of intervention could be helpful.

After explicitly detailing such drawbacks, the paper suggests ways to better investigate the effects of intervention. ...The paper also argues that the nonlinearity of intervention - which has largely been ignored in the literature on the effects of intervention - could be helpful in identifying the effects of intervention and overcoming simultaneity.

While I think Neely is tougher than he ought, particularly on high frequency research, this is certainly a useful paper for those interested in the economics of exchange rates.

The Fed and the US stock market

Another interesting paper by Hilde C. Bjørnland of the University of Oslo, this one written with Kai Leitemo from the Norwegian School of Management. Identifying the Interdependence between US Monetary Policy and the Stock Market (PDF), looks at how monetary policy affects stock markets - and vice versa. These are not small effects!

We estimate the interdependence between US monetary policy and the S&P 500 using structural VAR methodology. A solution is proposed to the simultaneity problem of identifying monetary and stock price shocks by using a combination of short-run and long-run restrictions that maintains the qualitative properties of a monetary policy shock found in the established literature (Christiano et al., 1999).

We find great interdependence between interest rate setting and stock prices. Stock prices immediately fall by one-and-a-half percent due to a monetary policy shock that raises the federal funds rate by ten basis points. A stock price shock increasing stock prices by one percent leads to an increase in the interest rate of five basis points.

Dornbusch's overshooting hypothesis revisited

Currencies are volatile and prone to "overshooting" (going above or below their expected ranges). Rudiger Dornbusch’s (1976) well known exchange rate overshooting states that the nominal exchange rate immediately appreciates with the increase in nominal interest rates, in line with uncovered interest parity (UIP). The problem is, many recent studies suggest otherwise.  As Hilde C. Bjørnland of the University of Oslo writes:

Instead they have found that following a contractionary monetary policy shock, the real exchange rate either depreciates, or, if it appreciates, it does so for a prolonged period of up to three years, thereby giving a hump-shaped response that violates UIP. These results have been so persuasive that the puzzles themselves are now about to be considered consensus, of which many recently developed DSGE models seek to replicate.

In Norges Bank working paper 2005/11, Monetary policy and the illusionary exchange rate puzzle (PDF), she argues there is amajor problem with VAR modesl used. They ignore the immediate effects of a monetary shock on the exchange rate:

The majority of studies quantifying the effects of monetary policy shocks have used the vector autoregressive (VAR) approach. A major problem facing these studies is how to address the simultaneity of monetary policy and the exchange rate. Most of the studies of open economies are placing zero contemporaneous restrictions on the response of the systematic interest rate setting to an exchange rate shock, or vice versa. However, this is not consistent with established theory neither on monetary policy nor on exchange rate determination. Furthermore, Faust and Rogers (2003) have recently shown that the delayed overshooting feature of the open economy VAR is very sensitive to this kind of restriction. VAR models of the open economy should therefore seek to identify monetary policy without restricting the contemporaneous response.

Her modelling suggests the Dornbusch hypothesis can be reconciled with the empirical data, if one "restricts the long run multipliers of the shocks, but leaves the contemporaneous relationship between the interest rate and the exchange rate unaltered". That is, she leaves "monetary policy ..free to influence the exchange rate".

Allowing for full simultaneity between monetary policy and the exchange rate, I find striking results; Contrary to the recent “consensus”, a contractionary monetary policy shock has a strong effect on the exchange rate that appreciates on impact. The maximal impact occurs immediately, and the exchange rate thereafter gradually depreciates back to baseline. This is consistent with the Dornbusch overshooting hypothesis. Furthermore, the ensuing movement of the exchange rate is with few exceptions consistent with UIP. Hence, I have found no evidence of the typical hump-shaped response found in the empirical literature, where the maximal impact occurs after 2-3 years...

To better understand these arguments, I suggest you open up the paper and compare the charts in Figure 1 with those in subsequent figures.

London: They're young, overpaid and over here

Hamish McRae explains why London is the world's financial centre, and is likely to remain so, in today's Independent on Sunday: They're young, overpaid and over here. And that's why London is thriving. London attracts more of the best financial talent in the world than New York, Tokyo or Frankfurt. His piece was prompted by last week's ONS earnings survey, which found that men working in Canary Wharf earned an average of more than £101,000 a year (US$176k):

These figures are of course a reflection of the pay in Britain's most successful industry, for though there are other employers, including three newspaper groups, financial services are the driver. This leads to a string of questions of which, from the economist's perspective, two stand out. Why are people paid so much? And how securely is this industry rooted in the UK?

The best way to get a handle on both questions is to look how well London does in this global business. The broad-brush answer is that as far as international finance is concerned it seems to be either level-pegging with its only real rival, New York, or pulling a little ahead of it. Both New York and London are increasing their lead over Tokyo, Frankfurt and Paris. The graph shows the national share of seven categories of international financial business, collated in a new paper this month from International Financial Services. The UK is ahead on four, the US on three and no other country is there at all.

The UK's leading four are: international banking, foreign equity trading, foreign exchange and one of the two types of derivative trading that's done outside organised exchanges. The three the US is ahead in are: exchange-traded derivatives, fund management and hedge funds.

These comparisons are a bit arbitrary, for some sectors are much larger than others: international banking is much larger than foreign exchange for example. They are also based on where the business is actually done, rather than on who owns the companies doing it. Thus the prime reason why London scores so high is that foreign commercial and investment banks do their international business out of London. That gives part of the explanation for the salary levels. These are global salaries, paid to attract the best people in the world.

London's financial workforce is multinational, well educated, and relatively young:

Are Britons really going bust?

Journalist responses to the recent UK insolvency figures have varied. Saturday's Guardian warned of Britons going bust. Opposition politicians railed against "a failure of economic management" and "irresponsible lending", while industry experts blamed consumerism and easy credit:

The Citizens Advice Bureau said it was coping with more than a million cases of serious indebtedness after a decade in which consumers have taken advantage of cheap credit to finance a prolonged spending spree.

...Industry experts agreed that the root of the problem was a combination of easily available credit and a greater willingness among consumers to take on debt without thinking through the consequences. "The ease with which you can obtain credit nowadays is a real problem and there are no central records so people often lie on credit card applications," said Louise Britten, a partner at insolvency group Baker Tilly. "The other problem is that we live in a 'want now, have now' society where nobody saves up for anything any more. They just buy it and worry about paying for it later."

But Bill Jamieson in The Business, 6 November, thinks fears of growing consumer indebtedness are exaggerated. He argues the household debt crisis has been overblown:

It all looks dire. But is there really a household debt crisis? The truth is that household finances have never been in better shape. Financial assets held by the household sector have never been higher. The insolvency figures need to be seen in the context of a huge increase in personal debt that smashed through £1 trillion (E1.47 trillion, $1.78 trillion) last year.

On the face of it this is a truly awesome figure. But it is one against which the incidence of default should be set. And in many cases, these defaults reflect changes in household circumstances rather than quality of initial lending decisions.In truth, we just do not know as yet whether this is “the tip of the iceberg” or exactly what was to be expected given the recent household borrowing boom.

He reminds us that UK households are actually getting wealthier - even after taking into account their growing personal and mortgage debt:

Explaining US personal bankruptcies

Personal bankruptcies are rising in the UK, but they have also been climbing in the US. A St Louis Fed article by Thomas A. Garrett and Lesli S. Ott in the October 2005 issue of The Regional Economist, Up, Up and Away: Personal Bankruptcies Soar!, usefully summarises the US research:

Researchers have found that the primary cause of personal bankruptcy is high levels of consumer debt often coupled with an unexpected insolvency event, such as the loss of a job, a major medical expense not covered by insurance, divorce or death of a spouse. Lower-income individuals are more likely to file for bankruptcy in response to an insolvency event, given their relatively limited access to financial counseling and fewer and less-diversified financial resources. The typical bankruptcy filer is a blue collar, high school graduate who is the head of a household in the lower middle income class with heavy use of credit, according to consumer economists’ surveys.

But it's not all due to rising consumer debt:

Several studies point to the decline in the social stigma related to bankruptcy as being partly responsible for the increase in filings. Also, the Bankruptcy Reform Act of 1978 is seen as an impetus for the record levels of bankruptcy filings in the 1980s and early 1990s. This law relaxed asset exemption levels and made it easier for individuals to file for bankruptcy. The rise and spread of casino gambling since the early 1990s also has been considered to be responsible, in part, for the rise in bankruptcies.

And nor is a rising bankruptcy rate necessarily a sign of a weakening economy:

Research suggests that bankruptcies may actually increase during periods of economic growth rather than during economic downturns. ...Bankruptcy levels rise during times of economic growth as people become more confident in the future and are willing to take on a greater debt burden and finance their increasing obligations based on current income.

However, as the supply of credit inevitably begins to tighten and interest rates and loan repayments begin to rise, the financial strain can become quite large. When this strain is coupled with an unexpected negative shock to income, an individual no longer has the ability to maintain the financial obligations undertaken in a time of economic exuberance.