October 1, 2010


European banks causing stress again
Ever since the global economic crisis started, concerns over the state of European banks have haunted the markets. In the first phase of the crisis, the major concern was about the exposure European banks had on US mortgage assets. In the second phase of the crisis, the concern has now shifted to the exposure European banks had on Europe sovereign debt.

Some experts had always doubted the way these banks were managed. Thus, even when European authorities announced stress tests for 91 banks in the region, experts were unimpressed. They doubted the authenticity of the stress tests. Even before the results were released, they said it will just be a cover-up based on assumptions. Surely enough, when the results came, only few banks were found to be in trouble.
Recent developments have proved the sceptics right. According to one Wall Street Journal report, some banks did not declare their true exposure to government bonds. Other banks excluded certain bonds, and many reduced the sums to account for “short” positions they held—facts that neither regulators nor most banks disclosed when the test results were published in late July. The exposure to government debt of at least some banks, such as Barclays and Crédit Agricole, was reduced by a significant amount. Adding to the haziness, sovereign-debt levels reported in the the stress tests differed, sometimes widely, from other international tallies (like BIS) and from some banks own financial statements.

ADRIAN BLUNDELL-WIGNALL and PATRICK SLOVIK, OECD economists, in a paper title “The EU Stress Test and Sovereign Debt Exposures” throw more light on the matter. The paper says banks only included government debt which was reflected in the trading books. They excluded the bonds held in banking books which are much larger in size.

The banking books contain more than 1.6 trillion euros in EU government bonds, compared to only 336 billion euros on the trading books, for a grand total of more than 1.9 trillion euros. Using the stress tests own worst-case scenario, the authors estimate that total losses of the banks would be 165 billion euros, compared to the stress tests estimate of only 26 billion euros.

Both these sources again led to concerns over Europe in September. Europe’s management of the crisis, evidently, leaves much to be desired.

Fiscal multipliers vary over business cycle
One important development of the economic crisis is the renewed focus on fiscal policy. Pre-crisis, it would be difficult to find even one paper on fiscal policy. Now, every other paper is on fiscal policy. Economists have actively started looking at various aspects of fiscal policy—institutional framework for fiscal policy, fiscal multipliers and so on..

In a recent paper (“Measuring the Output Responses to Fiscal Policy” , NBER Working Paper No 16311), ALAN J. AUERBACH and YURIY GORODNICHENKO say that fiscal multipliers differ depending on what part of business cycle you are on. The multiplier is between 1 and 1.5 in recessions and between 0 and 0.5 in expansions. Specifically, the authors find that defence spending has the largest multiplier, with the maximum response of output being $3.56 for every dollar of defence spending in a recession.

Another important finding is that the size of the multiplier tends to change relatively quickly as the economy starts to grow after reaching a trough. Thus, it is important to time the discretionary government spending properly to make it more effective.

This is a novel study which links fiscal multipliers to a business cycle. There are a large number of ongoing studies arguing whether fiscal policies are useful by estimating fiscal multipliers. But they only look at a particular event (say great depression or the current crisis) and are limited in scope. This paper looks at the entire business cycle and sees how fiscal multiplier changes. It is thus an important contribution to the fiscal policy debate.

Optimists vs Pessimists vs Agnosts
Boston Fed economists KRISTOPHER S. GERARDI, CHRISTOPHER L. FOOTE, and PAUL S. WILLEN have written an insightful paper on US housing market—“Reasonable People Did Disagree: Optimism and Pessimism About the U.S. Housing Market Before the Crash”. If there is one paper that needs to be read to understand US housing market crash, then this is the one. It summarises the debate which economists had before the crisis. Some economists said there is a bubble, some said there isn’t and others just presented facts without taking a view.

The paper adds that state-of-the-art tools of economic science were not capable of predicting with any degree of certainty the collapse of the US house prices. The asset-pricing literature does not yet have a firm grasp on when and why prices can deviate from market fundamentals over long periods of time. Even the best models have a difficulty in explaining many of the extremely large movements of asset prices that have characterised the financial markets in the past, including the stock-market crashes of 1929, 1987, and 2000–2002. Bubbles are a part and parcel of the financial activity and cannot be wished away. Hence the focus could be on ensuring that potential homeowners and investors understand the risks associated with their investments, and take necessary precautions against such declines.

Another important lesson from the crisis is that large declines in housing prices are possible and policymakers and economists must take this into account.

Understanding monetary policy in China

Hong Kong Monetary Authority’s economists CHANG SHU and BRIAN NG in “Monetary stance and policy objectives in China: A narrative approach” try to demystify Chinese monetary policy.

The paper tracks Chinese monetary policy using the narrative approach. This means scanning statements, speeches, reviews of Chinese central bank officials to help develop better understanding of the Chinese monetary policy. The PBoC uses a wide range of monetary tools, including market- or non-market-based, quantity and price-based measures, for some of which information is not available. Therefore, conventional measures, most notably the interest rate, may not fully capture the changes in monetary stance.
Based on two key official PBoC reports, this study compiles a number of indices to reflect the direction and intensity of monetary stance. These indices are shown to better gauge China’s monetary stance particularly in the early 2000s when market-based monetary tools were less used, but become increasingly correlated with the interest rate, a market-, price-based tool, in recent years.

The empirical analysis shows that the most important policy objectives are economic growth and inflation. Within growth and inflation, PBoC reacts more strongly to growth than inflation.
