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October 27, 2011

Latest Posts from Economist's View

Latest Posts from Economist's View

"Hayek on Monetary Policy and Unemployment"

Posted: 27 Oct 2011 12:33 AM PDT

David Glasner:

... Sixty years ago Hayek was arguing against an extreme version of Keynesian doctrine that viewed increasing aggregate demand as a panacea for all economic ills. Hayek did not win the battle himself, but his position did eventually win out, if not completely at least in large measure. Today, however, an equally extreme version of Hayek's position seems to have become ascendant. It denies that increasing aggregate demand can, under any circumstances, increase employment. I don't know what Hayek would think about all this if he were alive today, but I suspect that he would be appalled.

"The Elevated Position of the Financial Sector"

Posted: 27 Oct 2011 12:24 AM PDT

Wouter den Haan argues that measures of the financial sector's contribution to economic activity in the national income accounts overstate "its true value to a modern economy. As such, regulation that makes it more difficult for the sector to perform some activities is not necessarily a bad thing." This supports the arguments I've been making about the "mal-distribution of income" in recent years, so no disagreement here:

Why do we need a financial sector?, by Wouter den Haan, Vox EU: According to national-income account data, financial institutions are responsible for an important fraction of what countries produce each year. A standard way to measure a sector's contribution to GDP is to calculate its value added, that is, the difference between the value of the products produced minus the value of the products used in production.

This "value added" is distributed as income or reinvested in the financial sector.

  • Figure 1 displays the fraction of US GDP produced by the financial and insurance sector. During the post-war period this fraction increased from 2% to 8%.
  • The UK's financial sector generated 9% of total British value added in the last quarter of 2008; this was only 5% in 1970.1

Figure1. Value added of the finance and insurance sectors in the US (% of GDP)

: Bureau of Economic Analysis

An increase in inputs (capital and labour) is only part of the story. Value added per worker has also increased substantially. Weale (2009) reports that earnings per employee in the UK financial sector were 2.1 times average earnings in 2007. In Philippon and Reshef (2008), it is shown that the rise in the relative financial wage is related to financial deregulation.

The elevated position of the financial sector is even more obvious when we take a look at corporate profits.

  • In the first couple of decades following the Second World War, profits in the financial sector were around 1.5% of total profits;
  • Recently, this number was as high as 15%.

Pay versus output

Without doubt, these numbers indicate that the stakeholders in the financial sector (employees and investors) receive a substantial chunk of GDP. But the numbers do not necessarily imply that the sector produces this much. Nor do they imply that the actual value of what the sector produces has gone up a lot during the post-war period.

To understand why there could be a difference between the income received and the value of what is being produced, consider the basis of this deduction. In a competitive economy, the price of a good equals its marginal cost, and consumers buy it up to the point where their marginal benefit equals the price. If it is an intermediate good, the price equals the value of the good's marginal productivity to the purchasers. Thus, the value of output works well as a measure of both the cost and the benefit to society. That's the magic of the market.

However, if the sector is imperfectly competitive, the price will exceed the social marginal cost and we'll see value added being artificially transferred between sectors. As the financial sector is very concentrated, this is one reason we should expect the payments to factors in banking to exceed the value created – taking, as a base case, the prices that would be observed if the sector were competitive.

A second wedge between wage and value arises from the implicit insurance that the financial sector gets. As financial service providers do not pay for the "moral hazard" they create, the true value of financial services is systematically less than the payment to factors. Curry and Shibut (2000) calculate that the fiscal cost, net of recoveries, of the 1980s US Savings and Loan Crisis was $124 billion, or roughly 3% of GDP. This cost ignores other costs such as output losses, and this was a relatively mild crisis. Laeven and Valencia (2008) consider 42 crisis episodes and find an average net fiscal cost of 13.3%.2 It would not be fair to attribute these losses solely to the financial sector, but the magnitudes of the numbers suggest that this wedge could quantitatively be very important.

A third wedge comes from negative spillovers. The financial sector may provide services that are useful to a client, but not to society as a whole. For example, a financial institution may help to structure a firm's financing in such a way that the firm pays less taxes. Such a transaction would not increase production, unless lower taxes help the firm to produce more. Nevertheless, such transactions will count as value added generated by the financial sector. A rather stark analogy could be drawn with the cigarette industry, where it is quite clear that the payments to factors do not really measure social value added since the cost of smoking-induced health problems falls on the taxpayer (in most nations).

Although the sector's contribution is not easy to measure, there are some things we do know.

  • First, the financial sector provides useful services. That is, the sector's value added should be positive.
  • Second, financial-sector value added reported in the national income accounts was probably overvalued in the years leading up to Great Recession.

The financial sector extracted huge fees from the rest of the economy to construct opaque securities that were so complex that only a few understood how risky they were.3 If fees (prices) had accurately reflected the true value of the products, then some of these fees should have been negative, since many such products were not beneficial to the buyer or to society as a whole.

Several important questions need answers.

  • What are the reasons for the observed substantial increase in the share of GDP received by the financial sector?
  • What are the services that the financial sector in today's world does (or should) provide that increase the production of things we care about?
  • What is the value of these services? This is a tough question for the type of products delivered by the financial sector, because the nature of the services changes over time. For products like computers, we can measure characteristics such as speed and memory and measure how much computing power you get. If a bank becomes better at preventing default, then it provides more "financial services" for each unit of loans issued. But how can we correct for such changes in risk exposure? One possibility to measure the effectiveness of the services provided is to investigate how differences in financial sectors across countries are related to valuable characteristics such as smaller business cycles, better life-time consumption patterns, and innovative firms not facing financing constraints.4

What is the value of modern finance versus traditional finance?

Although the financial sector has been in the limelight since the outbreak of the crisis, these questions have received little attention. There is a substantial academic literature investigating the positive (and negative) effects of the presence of developed financial markets on long-term growth.5 But there is not that much research done on the question of which aspects of the current financial system are important for today's economies.

One would think that it is essential to fully understand what contributions the financial sector, and especially banks, can offer before engaging in a discussion on how to regulate this sector. If the key aspects of the financial sector that foster growth are relatively simple, then we would not have to worry that, say, increased capital requirements would have negative impacts on the economy. Then it would make more sense to worry about there being enough competition, so that we do not pay a lot for relatively simple activities. But if sustained economic growth requires a creative financial sector capable of performing complex tasks, then we should worry that regulation is not going to debilitate this sector.

It is surprising that these questions currently get so little attention. In an abstract sense, we know what roles financial institutions fulfil. In particular, (i) financial institutions avoid duplication both when monitoring loans and collecting information, (ii) they help to smooth consumption, and (iii) they provide liquidity.6 There are many enjoyable descriptions of some activities enacted in the financial sector that seem hard to reconcile with the laudable tasks thought of by economists. Moreover, knowing what the tasks of the financial sector are in theory does not tell us whether those tasks are fulfilled efficiently and at the right price. Nor does it tell us why the income earned by the financial sector has increased so much. As pointed out by Philippon (2008), in the 1960s outstanding economic growth was achieved with a small financial sector. Has it become more difficult to obtain information so that we now need to allocate more resources to the financial sector?

Some articles in the literature address the questions posed here. Chari and Kehoe (2009) use US firm-level data and find that the amount spent on investment exceeds the amount of internally-available funds (revenues minus wages minus material costs minus interest payments minus taxes) for only 16% of all firms considered. If investment could in principal be done using the firms' own funds, then the role for financial intermediaries is obviously diminished. Haldane (2010) discusses in detail the earnings of the financial sector and concludes that "risk illusion, rather than a productivity miracle, appears to have driven high returns to finance". Philippon and Reshef (2008) study wages earned in the financial sector and conclude that a large part of the observed wage differential between the financial sector and the rest of the economy cannot be explained by observables like skill differences, but is likely to be due to the presence of rents. Philippon (2008) argues that an increase in the types of firms that invest (young firms) can explain part of the increased income share of the financial sector; the increase in the last decade remains puzzling.

A similar view is expressed by Popov and Smets (2011), who argue that deeper financial markets in the US relative to those of the European continent are, to a large extent, responsible for the larger increases in productivity and faster pace of industrial innovation. One piece of evidence supporting this view is the empirical study of Popov and Roosenboom (2009), who find that better access to private equity and venture capital have a positive impact on the number of patents. Den Haan and Sterk (2011) reconsider the popular hypothesis that innovations in financial markets should make it easier for financial institutions to smooth business cycles. The idea of this hypothesis is that better access to bank finance ensures that consumers and firms do not have to make decisions that are bad for the economy as a whole, such as firing workers or postponing purchases which in turn could trigger additional layoffs. Den Haan and Sterk (2011) analyse in detail the behaviour of consumer loans and real activity, and find that there is no evidence that supports the hypothesis that financial innovations dampened business cycles, even when the recent crisis is excluded. Lozej (2011) addresses the same question using firm loans. Although the evidence presented by Lozej (2011) is a bit more mixed, there is at best weak evidence that the changes in the financial sector contributed to smaller business cycles during the period before the recent crisis.


The literature indicates that some tasks of the financial sector are beneficial, some attributes of financial institutions matter, and others matter less so or not at all. The recent publication of the Vickers report is a good occasion to investigate what activities of the financial sector are beneficial for today's way of life, and whether they are affected by proposed regulation. Without doubt, various proposed changes in regulation will be costly for the financial sector and make it more difficult for the sector to perform some activities. But that is not necessarily a bad thing. If a change would cost the financial sector, say, one billion a year but does not affect the total amount being produced, then it just means that there is an extra billion for the other sectors.


Chari, V. V., and Patrick J. Kehoe (2009), "Confronting models of financial frictions with the data", mimeo.
Curry, T., and L. Shibut (2000), "The cost of the savings and loan crisis: Truth and consequences", FDIC Banking Review, vol 13 no 2.
Demirguc-Kunt, Asli, Thorsten Beck, and Patrick Honohan (2008), "Finance for all? Policies and pitfalls in expanding access", World Bank: Washington, DC.
Den Haan, Wouter J., and Vincent Sterk (2011), "The myth of financial innovation and the great moderation", The Economic Journal 121, 707-739.
Gorton, Gary, and Andrew Winton (2003), "Financial intermediation", in George. M. Constantinides, Milton Harris and René. M. Stulz (eds.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 8, 431-552, Elsevier, Amsterdam.
Haldane, Andrew (2010), The contribution of the financial sector – miracle of mirage?,BIS.
Laeven, Luc and Fabian Valencia (2008), "Systemic Banking Crises: A new database", IMF working paper WP/08/224.
Levine, Ross (2005), "Finance and growth: theory and evidence", in Philippe Aghion and Steven Durlauf (eds.), Handbook of Economic Growth, edition 1, volume 1, chapter 12, 865-934, Elsevier, Amsterdam.
Lewis, Michael (1989), Liar's poker: rising through the wreckage on Wall Street, W.W. Norton & Company, New York.
Lowenstein, Roger (2000), When genius failed: the rise and fall of Long-Term Capital Management, Random House, New York.
Partnoy, Frank (1997), F.I.A.S.C.O.: blood in the water on Wall Street, W.W. Norton & Company, New York.
Philippon, Thomas (2008), "The evolution of the US financial industry from 1860 to 2007: theory and evidence", manuscript New York University.
Philippon, Thomas and Ariell Reshef (2008), "Wages and human capital in the US Financial Industry: 1909-2006", manuscript New York University and University of Virginia.
Popov, Alexander and Peter Rosenboom (2009), "Does private equity investment spur innovation", ECB working paper 1063.
Popov, Alexander, and Frank Smets (2011), "Financial markets: Productivity, procyclicality, and policy", manuscript European Central Bank.

1 Unless stated otherwise, the numbers in this paragraph are from Haldane (2010).
2 The highest net fiscal cost was equal to 55.1% and attained during the 1980 Argentinian crisis. In contrast, the net fiscal cost of the banking crisis in Sweden during the early 1990s was close to zero.
3 There are many other examples. I recently transferred €10,000 from a Dutch Euro account to a Euro account held by a British bank. The transfer cost me €455. That is, a personal loss of 4.6% in one day. Given that the costs are virtually zero, the fees would be almost fully counted as value added in the national income accounts.
4 An example is Popov and Roosenboom (2009).
5 Levine (2005) provides an excellent survey and concludes that a well-developed financial sector is beneficial for growth. Demirguc-Kunt, Beck, Honohan (2008) argue that in some cases the effect could be the opposite.
6 See Gorton and Winton (2003).
7 See, for example, Lewis (1989), Lowenstein (2000), and Partnoy (1997).

links for 2011-10-27

Posted: 27 Oct 2011 12:06 AM PDT

Fed Watch: Waiting, Waiting, Waiting"

Posted: 26 Oct 2011 03:24 PM PDT

Another post from Tim Duy:

Waiting, Waiting, Waiting, by Tim Duy: US markets are closed, with everyone left waiting for the news from Europe and the 3Q11 US GDP report. Expectations appear to be high for both, but I am considerably more certain the latter will deliver on those expectations. Europe is certainly more interesting. Over the last few weeks, market participants looked to have grasped at every little straw that offered hope on the European story, and it remains to be seen whether or not that will continue when rumours turn to news.

I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months. Some specific concerns:

The goalposts are already moving. The Eurozone economy is headed into recession - the combination of fiscal austerity and financial turmoil have already set in motion the inevitable contraction of demand that will soon threaten deficit reduction goals across the continent. And it is only a matter of time before the ratings agencies recognize this as well. The European solution, of course, will be additional fiscal austerity. It didn't work in Greece, and it won't work for the Eurozone as a whole.

The lack of sufficient ECB participation. The German contingent has effectively shut down the ECB. From the Wall Street Journal:

Lawmakers also pressed Ms. Merkel to push banks considered systemically relevant to raise core capital to 9% by a deadline of June 30, 2012 and urged her to insist on an end to the European Central Bank's program of purchasing euro-zone bonds on the open market to prop up weakened euro-zone members as soon as the EFSF is launched. German lawmakers also called for a clear European commitment to the ECB's independence.

The Germans fear the inflationary consequences if the ECB essentially monetizes the debt of the periphery. But the lack of a credible lender of last resort is crippling rescues efforts, and will continue to do so.

When in doubt, turn to financial engineering. The faith in financial engineering never ceases to amaze me. Efforts to leverage up the EFSF are almost comical, and they reveal another problem in this exercise - no one (in particular, Germany) is willing to bring sufficient resources to the table. Wolfgang Munchau:

Leverage can have different economic functions, but in these cases it simply disguises a lack of money.

The whole issue of leverage looks to be little more than a smoke and mirrors effort to make the real firepower of the fund appear to be much greater than reality.

Turning to developing nations for help. If it wasn't so sad, it would almost be funny. Reports of BRIC participation as EFSF investors have been circulated for weeks. The latest version that reportedly sparked today's market rally:

French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.

My goodness, have the Europeans learned nothing from the Americans? Sure, we let the fox into the hen house and didn't have the common sense to chase him out a decade ago. The Europeans are now opening the doors and inviting in the fox. Michael Pettis had a long, must read piece on this topic earlier this month:

In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd. European governments are unable to fund themselves not because Europe needs foreign capital. It has plenty. They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack credibility.

Foreign money does not solve the credibility problem. What's worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus. In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.

The idea on the table is for the BRICs to buy into the EFSF, not struggling debt directly. Even so, they need Euros to buy EFSF debt, which will represent a capital inflow into Europe. The periphery nations are struggling to rebalance internally. The strong Euro is not helping matters. Ultimately, additional capital inflows from the BRICs will only add additional strength to the Euro, encouraging further contractionary external adjustment that only complicates the internal adjustment challenges. The Europeans really should be seeking a European solution, not adding more external stakeholders to the fray.

I guess we should all get some good sleep tonight, as tomorrow will be a busy day.

Wither CDS?

Posted: 26 Oct 2011 11:07 AM PDT

Tim Duy:

Wither CDS?, by Tim Duy: Something I have been wondering about in the context of the supposed "voluntary" writedowns being forced upon holders of Greek debt - what exactly is the point of the credit default swap market for sovereign debt if politicians will act to ensure that any default never triggers a credit event? The FT provides an answer:

Now, politicians are seeking to take their revenge: not just with the recent introduction of bans on some trading of credit default swaps but also in their attempts to ensure that any haircut on Greek government bonds does not trigger a credit event.

Combined, these two events could spell the end of the credit default swaps market, say bankers.

The end of the credit default swap market might not be without consequences:

But these aims could backfire. Some bankers believe, rather than lowering borrowing costs, these moves will have the reverse effect and also restrict lending to their banks and companies.

In the wake of the CDS ban, some banks are already pushing alternative strategies that risk driving up government bond yields even further. Last week Citigroup, the leading US bank, recommended selling the bonds of France, Italy and Spain because of the trading ban while other banks have warned they could unload peripheral bonds if CDS payouts are ruled out on Greece.

Not exactly a good time for higher rates in the periphery. Will the loss of the CDS market ultimately improve or undermine financial market functioning? This is outside my area of expertise, leaving me particularly curious on how events unfold.

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