New Economist

Was it really due to easy money?

Yale's Robert J. Shiller has a forthcoming article in the Brooking Papers on Economic Activity which questions the popular interpretation that asset booms since the mid 1990s were a direct consequence of falling long-term interest rates. The paper, Low Long-Term Interest Rates and High Asset Prices (PDF), was prepared for a "Celebration of BPEA” Conference being held at the Brookings Institution last week. Here are Shiller's conclusions:

We have seen here that the big movements in stock prices and real estate prices in the last decade or so do not line up with movements in long-term interest rates over the same time period. This appears to confirm the 1988 results of Campbell and Shiller that stock prices relative to dividends or earnings are not well explainable in terms of present value models with time-varying interest rates.

Yet if we are doing very broad comparisons of the present time with another time, comparing the early 1980s when interest rates were very high with today, we might say that lower nominal interest rates are indeed a factor in the relatively higher asset prices we see today. ...Presumably, as I discussed in Irrational Exuberance, there are many factors, including speculative feedback, that have contributed to high asset prices today.

This paper began by considering a certain common belief about the way the world works which was motivation for this paper. We see that the idea that we should think of the level of long-term real interest rates as the dominant force in driving long-term asset prices up or down is not supported by the evidence.

Tackling financial distress: BIS calls for 'speed limits'

Considerable attention has been devoted to the annual Federal Reserve gathering at Jackson Hole this Labor Day weekend. For a good summary see Brad de Long's post I Am Not at the Jackson Lake Lodge This Labor Day Weekend, James Hamilton on The Taylor Rule and the housing boom, and Greg Ip's report Two Heavyweights Weigh in on Greenspan’s Legacy

But another recent central bank gathering is worth mentioning. The Reserve Bank of Australia held their annual research conference late August, concentrating this year on a very timely topic, the structure and resilience of the financial system. While some attention has been given to the paper by Fed Reserve Board's Karen Dynan and Donald Kohn, The Rise in U.S. Household Indebtedness: Causes and Consequences (PDF), I particularly enjoyed a paper by BIS official Claudio Borio: Change and Constancy in the Financial System: Implications for Financial Distress and Policy (PDF). Borio argues that a phase of "major structural change" in financial markets has "spawned an extraordinary variety of new instruments and markets" in recent decades, while the volume of transactions "has surged to unprecedented highs".

These profound changes have had implications for the potential dynamics of financial distress. Financial distress is more likely to involve the evaporation of market liquidity and to have far-reaching cross-border effects. New players are more likely to be at its origin and/or to amplify it. The dynamics of distress may have become more unpredictable. And the transfer of risk to the household sector may arguably have lengthened the time lag between the build-up of embedded risk in the financial system and its overt emergence.

But the sea-changes we have observed should not blind us to what has remained constant. For it is what has not changed that holds the key to the more durable aspects of financial instability. This paper has argued that the main form of financial instability with potentially serious macroeconomic costs has historically been, and continues to be, overextension in risk-taking and balance-sheets in good times, masked by the veneer of a vibrant economy, ie. the occasional build-up of financial imbalances that at some point unwind, inflicting damage on the economy.

What is behind this tendency for excessive risk-taking? The usual four horsemen of the (financial) apocalypse:

And behind this form of instability hide four enduring characteristics of financial activity and human behaviour, viz. deep-seated and pervasive (asymmetric) information problems in financial relationships; powerful positive feedback mechanisms within the financial system as well as between the financial system and the real economy; limitations in risk perceptions; and limitations in incentives. The sea-changes observed may affect the specific manifestation of these elements and their prominence, but should not be expected to alter them in a fundamental way.

What are the policy implications? Borio sees a the need to design and implement "effective speed limits" for financial markets:

..more could be done in designing policies that would seek to limit overextension in risk-taking and balance sheets (“speed limits”). Admittedly, very good work has been done in encouraging improvements in risk measurement and management and in risk disclosures. Even so, given limitations in risk perceptions and incentives, the effectiveness of these steps may not, in the end, fully match expectations.

Ideally, speed limits would become more binding as the risk of overextension increases. Three guidelines could inform their design. First, as with fiscal policy, on balance built-in stabilisers appear superior to discretionary measures. This could be achieved, for instance, by calibrating prudential instruments based on experience over whole business cycles or stress estimates. Second, discretionary measures could be deployed to complement built-in stabilisers if and when it was judged appropriate. This could help to tailor the measures to specific features of the overextension. Third, close cooperation between different authorities with responsibility for, or whose policies impinged on, financial stability would be needed. This would involve prudential and monetary authorities in the first instance, but also accounting standard setters and tax authorities.

...Despite the challenges, some progress in this direction has been made in recent years. Continuing to travel along this road holds out the prospect of edging closer to securing lasting financial stability.

BIS is often overlooked by the financial commentariat; much of their work is done quietly behind the scenes. But where BIS leads, central banks often follow. Watch this space.

Offshoring financial services: 'Build, optimize and release'

The BBC News reports on a Deloitte study which claims an offshore boost for the UK finance sector

The shifting of UK financial services jobs to developing countries such as India and China has saved the sector about £1.5bn a year, a study suggests.

Accountants Deloitte said the number of financial jobs going overseas over the past four years had increased 18-fold. More than 75% of major financial institutions have operations overseas, compared with fewer than 10% in 2001.

Chris Gentle, associated partner for financial services at Deloitte and author of the study, said: "Financial institutions need to re-engineer business processes, or risk simply transferring offshore the legacy inefficiencies of older, onshore processes."

The Global Financial Services Offshoring Report 2007 finds signs of strong growth and growing maturity:

The offshoring industry is growing up quickly. Most major financial institutions now operate a sizeable, low-cost offshore delivery function. The industry’s cumulative cost savings for the last four years have risen sharply, propelled by an 18-fold increase in offshore headcount.

Over 2006, average total headcount offshore doubled to six percent of total group staff. More than half of all financial institutions surveyed are now saving more than 40 percent for each business process offshored.

But there's more to come: as the industry grows, offshoring and sourcing decisions should not be "based purely on cost arbitrage grounds":

In future, the best offshoring strategies cannot be based solely on financial gains from labor arbitrage. Otherwise the legacy inefficiencies of older, onshore processes may simply be transferred offshore.

...Enter Phase II: The DTT GFSI group’s analysis has identified three phases to an offshoring journey for financial services institutions: Build, Optimize and Release. Organizations can realize the full value from their offshore operations only when all three phases are complete.

As financial institutions enter the second offshoring phase, their efforts are on streamlining migrated business processes. The impact of this application on best practices is becoming evident across all financial services. A select group of financial institutions – offshoring’s stars – has successfully deployed aggressive offshoring strategies, resulting in the transfer of more than five percent of group headcount offshore and achieving bottom line savings in excess of 40 percent. In some instances these savings have been equivalent to three percent of their total cost base. Other institutions, that have failed to apply the best practices have, in some instances, experienced a decline in their operational performance. This has put their prospects of realizing full future value from their offshoring operations at risk.

Deloitte's are clearly using this report to tout for business. But the trends they point to are no less real for that. Six per cent of staff may not sound that much, but if it has doubled in just four years it could easily double again.

Liberate prediction markets

The new Statement on Prediction Markets, published by the AEI-Brookings Joint Center for Regulatory Studies, could hardly have a more luminous bunch of authors: Kenneth Arrow, Thomas Schelling, Hal Varian, Daniel Kahnemann and Vernon Smith to name a few. Their plea is a simple one:

We argue that U.S. regulators should lower barriers to the creation and design of prediction markets by creating a safe harbor for certain types of small stakes markets. We believe our proposed change has the potential to stimulate innovation in the design and use of prediction markets throughout the economy, and in the process to provide information that will benefit the private sector and government alike.

Though Steve Levitt refused to sign up, ostensibly because he did not think "the letter went far enough", I am sure this is a cause most economists would endorse. You can add New Economist to the pile...

The rise of the euro

Conclusion: the euro will for the foreseeable future be by far the most important alternative to the dollar.

So writes Deutsche Bank economist Werner Becker in a new paper, Euro riding high as an international reserve currency (PDF). The euro's share of global foreign exchange reserves rose from 18% at the start of 1999 to around 25% by the end of 2003. Becker cites four factors why DB expect the euro share of global foreign exchange reserves to rise to 30-40% by 2010.

The vulnerability of the US dollar given the huge current account imbalances, the changes in exchange rate regime (e.g. changeover from a dollar peg to a basket of currencies with the euro as a core element as in the case of China), the central banks’ growing investment requirements and the increasing focus on returns.

But after 2010 the outlook is more murky. We could see a dollar renaissance. As for the yuan, don't hold your breath: while it has the potential to become an international currency, this will not be "until well after 2010." 

The road to India

More evidence of the global relocation of white collar labour today. The week before last, Citigroup announced it was to cut 17,000 jobs, and relocate 9,500 to India and other "lower cost locations". Today we read of another bank slashing jobs in the west and offshoring others: Barclays to Shift 10,800 Jobs to India, Elsewhere to Cut Costs, according to Bloomberg reporters Subramaniam Sharma and Chitra Somayaji:

Barclays Plc plans to shift 10,800 jobs to India and other low-wage countries, betting reduced costs will help win support for its acquisition of ABN Amro Holdings NV, the world's largest financial services takeover. Barclays, Britain's third-largest bank, will also slash about 12,800 jobs to pare expenses by 2.8 billion euros ($3.8 billion), the banks said in a statement today.

Barclays, based in London, today agreed to buy ABN Amro for 67 billion euros. Salaries in insurance, banking and finance in India may rise 16.5 percent this year, driving the fastest wage growth in Asia, according to Hewitt Associates Inc. Aviva Plc, HSBC Holdings Plc and Standard Chartered Plc have hired back-office staff in India, where a financial analyst costs as little as a quarter of counterparts in Europe, Paul Abraham, managing director of ABN's global support unit, said last month.

...Barclays Chief Executive Officer John Varley today said the London-based bank will move staff to "low-cost'' locations including India, without elaborating. Barclays's acquisition of Amsterdam-based ABN Amro will create a bank with about 217,000 employees and 47 million customers stretching from India to Brazil.

Barclays plans to slash almost 6 percent of the combined workforce, excluding Chicago-based LaSalle Bank...."Part of the expected staff reduction will be through establishing shared services and offshoring those positions to low-cost locations, such as India where new staff will be recruited at ABN Amro's existing'' operations, the banks said in the statement. "The reduction in staff is a necessary part of the envisaged synergies from the combination of the two banks.''

ABN Amro, which employs about 4,000 back-office workers in six offices in Mumbai, Chennai and New Delhi, plans to hire as many as 2,000 more people in India by March, Lars Gustavsson, global head of the services unit, said on March 15.

Global banks have been ripe for restructuring, with many 'back office' jobs in particular not needing to be done in the same location as sales or trading. Some banks and insurance companies have been quietly shifting those jobs to India and elsewhere for years, of course. But relocation seems to be accelerating, as Indian expertise improves and capacity to deliver grows apace.

Citi cuts city jobs

Citigroup announced yesterday it was cutting 17,000 job cuts in an effort to save $2.1bn this year; this is a 5% cut in staff levels. Many of the cuts will be in support functions such as legal, human resources and finance. Most job cuts will be outside the US, of course - confirming the age old rule in investment banking that the further away you are from head office the more at risk is your job. While most press attention has been on the headline job cuts, the press notice also said:

More than 9,500 jobs will be moved to lower-cost locations, both domestically and internationally, with about two-thirds through attrition.

For that, read offshoring to India and other sites. In this, Citibank is simply catching up with the current practice of HSBC and other global banks. But a sign of the times, nonethless. According to Tara Ricks from City headhunters Joslin Rowe:

Citigroup already employs 19,000 people in India and is geared up to take on lots of extra people there.

Today's Financial Times warns that Citigroup’s bloat carries lessons for Barclays and others:

Here is a cautionary tale for Barclays and ABN Amro, the European banks that are negotiating a merger. Citigroup has discovered just how difficult it is to manage a megabank. Citigroup’s announcement of 17,000 job cuts in an effort to save $1.7bn this year was accompanied by some humble pie. Through mergers, the bank has accumulated excess layers of middle management and inefficient back and middle offices, which it is belatedly trying to eliminate.

One interesting twist - the high performers are not at risk. The Evening Standard reports:

Senior managers have been told to go through records and axe the poorest performers. Staff will learn within weeks whether they are to be paid off. ...Sources said anyone earning over £1 million would be safe because they were high performers. But anyone taking home less than that is in the line of fire.

Don't worry guys - your Ferrari and Fulham mansion are safe!

The economics of private equity funds

With most of the commentariat arguing the pros and cons of private equity, it surely wouldn't hurt to inject a little economics into the debate. Enter Andrew Metrick and Ayako Yasuda from the Wharton School, with their new paper: The Economics of Private Equity Funds (PDF).

This paper analyzes the economics of the private equity industry using a novel model and dataset. We obtain data from a large investor in private equity funds, with detailed records on 249 funds raised between 1992 and 2006. Fund managers earn revenue from a variety of fees and profit-sharing rules. We build a model to estimate the expected revenue to managers as a function of these rules, and we test how this estimated revenue varies across the characteristics of our sample funds.

We find major differences between venture capital (VC) funds and buyout (BO) funds – the two main sectors of the private equity industry. In general, BO fund managers earn lower revenue per managed dollar than do managers of VC funds, but nevertheless these BO managers earn substantially higher revenue per partner and revenue per professional than do VC managers.

Furthermore, BO managers build on their prior experience by raising larger funds, which leads to significantly higher revenue per partner and per professional, despite the fact that these larger funds have lower revenue per dollar. Conversely, while prior experience by VC managers does lead to higher revenue per partner in later funds, it does not lead to higher revenue per professional.

Taken together, these results suggest that the BO business is more scalable than the VC business. These results can help explain why the late 1990s growth of the VC sector was a failure, while the BO sector has continued to grow in the 21st century.

This helps to explain why buyouts are booming; but I suspect the IT bust was also a factor. Those venture capitalist had to go somewhere... and in a low volatility world desperate for yield and facing greater regulatory burdens for listed equity, private equity was bound to make headway.

Private equity, part 1

There's been much hoo-ha about the evils of private equity lately. Tonight's BBC Radio 4's In Business programme - to be rebroadcast Sunday night - provided a good overview of the UK debate: Private grief.

Private equity firms' influence is increasing. They have huge resources that mean they can seek to control some of Britain's biggest companies -- such as Sainsbury's -- in their search for profit. But with their growing power comes increasing concerns.

Do private equity firms really create value for the British economy? Or do they - as their critics charge -destabilize previously sound companies through financial engineering? And could the huge debts involved in private equity lead to grief for the economy as a whole? Peter Day returns to the world of private equity to find out.

Contributors
Grant Hearn chief executive, Travelodge
Charles Sherwood partner, Permira
Paul Maloney, national organiser, GMB union
Jon Moulton founder, Alchemy Partners
Rod Selkirk chairman, BVCA, and chief executive, Hermes Private Equity 

Curtains for the greenback?

The mighty greenback is slowly but surely losing its pre-eminence as the world's reserve currency. Consider the evidence:

1. The US dollar has fallen by more than 10 per cent against the euro and 14 per cent against the pound this year.

2. Asian central banks have been steadily diversifying their holdings away from USD-denominated assets into the euro, yen and pound.

3. Key petrodollar economies such as Iran, the UAE, Indonesia and Venezuela have said  they are looking to shift their reserves into euros or to price oil sales in the currency.

4. Today's Financial Times reports that Euro notes have overtaken the dollar:

The US dollar bill’s standing as the world’s favourite form of cash is being usurped by the five-year-old euro. The value of euro notes in circulation is this month likely to exceed the value of circulating dollar notes, according to calculations by the Financial Times. Converted at Wednesday’s exchange rates, the euro took the lead in October.

The figures highlight the remarkable growth in euro notes since their launch on January 1 2002, three years after the start of Europe’s monetary union, which in January welcomes its 13th member – Slovenia, the former Yugoslav republic.

“After the launch, we expected growth to stabilise – but it has continued over five years,” Antti Heinonen, head of the European Central Bank’s bank notes directorate, told the Financial Times.

Although the ECB does not deliberately promote the international use of the euro, it has become popular in official foreign exchange reserves – even if it is far from challenging the dollar’s lead as the most popular reserve currency.

Individually, these might be dismissed. Together, they point to a gradual erosion of the greenback's long standing dominance of global currency markets and central bank reserves.

I don't see this gradual diversification as a problem for markets - though there will be the odd exchange rate and asset class dislocation as large holdings shift. Nor does it augur the greenback's imminent collapse; more like a gradual weakening.

In time I expect it will be the yuan - rather than the euro - which comes to rival the dollar as the world's most traded currency (though clearly we are still a long way from that).

UPDATE: Felix Salmon of Economonitor offers five main reasons why there are more euros in circulation than greeenbacks. Meanwhile Dean Baker has this to say:

First, the dollar is not essential to world finance. People are happy to hold euros and other currencies, no one needs to hold dollars. Second, the euro passing the dollar is not some sort of cataclysmic event.

As long as people still have faith in the basic soundness of the dollar, they will be happy to hold it, even if it slides to number 2 by some measures. Of course, if investors become convinced that the currency is on a downward path, then it could lead to a serious run.

In short, the world does not need the dollar, but it is also not anxious to throw it in the toilet, or at least not yet.