Archive for the 'Finance' Category

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Note to self: holidaying in Greece will soon be cheap

Published on 3 February 2010 at 12:52 pm in Development, Economics, Europe, Finance and Politics. Tags: , , , , , .

Megan McArdle directs the world to this piece in the FT.  From the FT article:

The European Commission said on Tuesday it would endorse Athens’ plan to bring back under control the public sector deficit, which last year reached almost 13 per cent of gross domestic product.
…
Under a three-year plan, the Greek government seeks to cut the national budget deficit to less than 3 per cent of GDP by the end of 2012.

and:

In response to criticism that earlier plans had not included sufficient spending cuts, Mr Papandreou also announced an across-the-board freeze in public sector wages which, together with cuts in allowances, would reduce the public sector wage bill by 4 per cent. The government has also pledged to raise the retirement age.

If the Greek government can achieve this without massive, nation-wide strikes, I’ll be terrifically impressed.  Megan’s comments:

Everyone is expressing optimism. But while this sort of belt-tightening is necessary for Greece to stay in the EU, it’s going to come at a huge cost. Greece is already in recession–that’s why its budget problems loom so large–and the fiscal contraction will only make them deeper. Meanwhile, the EU will be setting its interest rates to meet the needs of larger, healthier members (and inflation-hawk bondholders). Tight fiscal and monetary policy means a long, painful period ahead for the Greeks.

This is the dilemma that faced Argentina with its monetary peg to the dollar; ultimately, it led to devaluation and default. We will see if Greece can whether [sic] it better.

I don’t think that this sort of belt-tightening is strictly necessary in the near term.  Germany will, again, fund a bail-out if it really comes down to it because, if nothing else, the loss to Germany of a member of the EU dropping the currency is greater than the loss to Germany of paying for Greece’s debt.

It’s clearly necessary in the long term that Greece get it’s fiscal house in order, but since they’re in such a severe recession, this isn’t really the time to do it (financial market pressure aside).  This is, in essence, the same debate that is gripping America, although there the pressure to address the deficit is coming from a successful political strategy of the opposition rather than, much as that same opposition might like, pressure from the markets.

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment.  Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment.  The latter is difficult in Europe with it’s multitude of languages, but not impossible.

In a perfect world where all regions of the EU currency zone were equally developed, this would simply replace the EU development grants.  But this isn’t a perfectly world …

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A blast from the past

Published on 26 January 2010 at 3:45 pm in Economics, Finance, Justice/Law and USA. Tags: , , , , , .

Back in June of 1987 (!), the New York Times interviewed Edward W. Kelley Jr. just as he joined the Federal Reserve’s board of governors.  How’s this for a quote?:

Q. Mr. Volcker has been considered something of a foot-dragger on bank deregulation. Where do you stand?

A. I’m philosophically in favor. The deregulation we’ve had over the last few years has been highly beneficial and I would favor further deregulation of the financial services industry. But there’s an overriding public interest in making sure the integrity of those types of institutions is maintained. I really do not want to run any meaningful risks that we deregulate at a speed or in a way that would imperil that.

Brilliant!

[Hat tip to my new favourite blog (ok, so I'm two years behind the times), Economics of Contempt]

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Obama’s (i.e. The Volcker) bank plan

Published on 25 January 2010 at 4:37 pm in Economics, Finance, Justice/Law, Politics and USA. Tags: , , , , , , , , .

Those of us who aren’t American but still follow U.S. politics were quietly giggling (okay, openly guffawing) into our latte’s last week when Scott Brown won the special election to replace the late Ted Kennedy.  The Daily Show’s take on the whole affair (I think it was broadcast the night before the election day) was spot on and I urge anyone with the capability to hunt down that episode.  In short, the Democrat’s handling of the event is a classic example of why the word clusterfuck was invented. What in blazes they now intend to do in passing any reasonable kind of reform in health-care (and the ideas on the table weren’t really all that reasonable to start with) is beyond me.

Anyway.  I tip my hat to the newest federal Senator in the United States for an expertly handled campaign.

I was then surprised to (finally) see some equally smart politics from the White House in the form of Obama publically supporting the banking regulation ideas of former Fed chair and octogenarian, Paul Volcker.

The White House had already been making noises about imposing a fee on financial institutions to recoup any losses in TARP.  TARP, if you remember, is the US$700 billion officially set aside under president Bush Jr. to help the finance industry weather the storm.  Of course, a large fraction of TARP was diverted to help the car (that’s “auto” for any Americans in the audience) industry and not all assistance to the financial industry was included in TARP.  Still, it’s the closest thing to an easy target with a pronounceable name.  If you care, you can read my incredibly brief thoughts on the levy here and, more importantly, here.

But the Volcker plan is an entirely different kettle of fish and can be boiled down to a simple and beautiful phrase:  “Too big to fail is just too big.”

It calls for constraints on the scope and the size of US banks.  It seeks to ban proprietary trading at institutions that hold retail deposits.  It’s an armchair commentator’s wet dream come true!  It’s also, unfortunately, staggeringly unlikely to ever become reality.  There are two reasons for this.

First, as expertly described by the Economics of Contempt, the White House has no intention of pushing this through anyway.  Instead, it was …

… a fairly transparent political stunt — the White House needed to do something to take the media’s focus off of health care 24/7, so they flew in Volcker and announced some proposals that sound good to the media. The two Senate staffers I talk to regularly both said their offices were basically ignoring Obama’s proposals, because even if the White House fights for them (which they won’t), Chris Dodd has no intention of inserting them into his committee’s bill. I like how some people think Obama’s proposals represent a fundamental turning point on financial reform, because….well, clearly this is their first rodeo. (Hence the uber-quixotic language they use to describe financial reform.)

[Update: Just to clarify, when I said Obama's announcement was a "fairly transparent political stunt," I wasn't criticizing the Obama administration. We live in a political world, and political stunts are often useful. If I were Rahm Emanuel, I'd be a dick have done the same thing. I think it was probably a savvy move, and if health care reform ends up passing, then it was worth it.]

Second, the U.S. Supreme Court, in the second move in the space of a week to leave the America-watchers of the world chuckling, decided to reverse decades of precedent and assert that when it came to political speech, corporations, unions and other groups of individuals have more power than individuals.  Not only can corporations, unions and the like directly fund political campaigns, but unlike individuals, they are subject to no limit on their donations.  It’s great.  You’re going to end up seeing major political events sponsored by Pepsi.  You’re going to have unlimited funding available to opponents of any politician that does anything that runs contrary to a company that employs people in his or her district or state.  In short, you will never, ever again see anything serious passed in an election year in the United States unless it has not just bipartisan, but unanimous support.

So, no, as much as I like what Obama said, I don’t think it’ll ever become law.  It certainly won’t in 2010.

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More on the US bank tax

Published on 15 January 2010 at 5:15 pm in Finance and USA. Tags: , , , , .

Further to my last post, Greg Mankiw — who is not a man to lightly advocate an increase in taxes on anything, but who understands very well the problems of negative externalities and implicit guarantees — has written a good post on the matter:

One thing we have learned over the past couple years is that Washington is not going to let large financial institutions fail. The bailouts of the past will surely lead people to expect bailouts in the future. Bailouts are a specific type of subsidy–a contingent subsidy, but a subsidy nonetheless.

In the presence of a government subsidy, firms tend to over-expand beyond the point of economic efficiency. In particular, the expectation of a bailout when things go wrong will lead large financial institutions to grow too much and take on too much risk.
[...]
What to do? We could promise never to bail out financial institutions again. Yet nobody would ever believe us. And when the next financial crisis hits, our past promises would not deter us from doing what seemed expedient at the time.

Alternatively, we can offset the effects of the subsidy with a tax. If well written, the new tax law would counteract the effects of the implicit subsidies from expected future bailouts.

My desire for a convex (i.e. increasing marginal rate of) tax derives from the fact that the larger financial institutions are on the receiving end of larger implicit guarantees, even after taking their size into account.

Update:  Megan McArdle writes, entirely sensibly (emphasis mine):

That implicit guarantee is very valuable, and the taxpayer should get something in return. But more important is making sure that the federal government is prepared for the possibility that we may have to make good on those guarantees. If we’re going to levy a special tax on TBTF banks, let it be a stiff one, and let it fund a really sizeable insurance pool that can be tapped in emergencies. Like the FDIC, the existance of such a pool would make runs less likely in the shadow banking system, but it would also protect taxpayers. Otherwise, with our mounting entitlement liabilities, we run the risk of offering guarantees we can’t really make good on.

I agree with the idea, but — unlike Megan — I would allow some of it to be collected directly as a tax now on the basis that the initial drawing-down of the pool came before any of the levies were collected (frustration at the political diversion of TARP funds to pay for the Detroit bailout aside).

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The US bank tax

Published on 14 January 2010 at 4:47 pm in Finance, Politics and USA. Tags: , , , .

Via Felix Salmon, I see the basic idea for the US bank tax has emerged:

The official declined to name the firms that would be subject to the tax aside from A.I.G. But the 50-odd firms, which include 10 to 15 American subsidiaries of foreign institutions, would include Goldman Sachs, JPMorgan Chase, General Electric’s GE Capital unit, HSBC, Deutsche Bank, Morgan Stanley, Citigroup and Bank of America.

The tax, which would be collected by the Internal Revenue Service, would amount to about $1.5 million for every $1 billion in bank assets subject to the fee.

According to the official, the taxable assets would exclude what is known as a bank’s tier one capital — its core finances, which include common and preferred stock, disclosed reserves and retained earnings. The tax also would not apply to a bank’s insured deposits from savers, for which banks already pay a fee to the Federal Deposit Insurance Corporation.

i.e. 0.15%.  It’s certainly simple and that counts for a lot.  It’s difficult to argue against something like this.

I would still have liked to see it as a convex function so that, for example, it might be 0.1% for the first 50 billion of qualifying assets, 0.2% for the next 50 billion and 0.3% thereafter.

Better yet, pick a size that represents too big to fail (yes, it would be somewhat arbitrary), then set it at 0% below, and increasing convexly above, that limit.

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On interest rates

Published on 23 November 2009 at 12:05 pm in Economics, Finance and USA. Tags: , , , , , .

In what Tyler Cowen calls “Critically important stuff and two of the best recent economics blog posts, in some time,” Paul Krugman and Brad DeLong have got some interesting thoughts on US interest rates.  First Krugman:

On the face of it, there’s no reason to be worried about interest rates on US debt. Despite large deficits, the Federal government is able to borrow cheaply, at rates that are up from the early post-Lehman period … but well below the pre-crisis levels:

DESCRIPTION

Underlying these low rates is, in turn, the fact that overall borrowing by the nonfinancial sector hasn’t risen: the surge in government borrowing has in fact, less than offset a plunge in private borrowing.

So what’s the problem?

Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade; this could, they believe, drive rates way up, even though this possibility doesn’t seem to be priced in by the market.

What’s wrong with this picture?

First of all, what would things look like if the debt situation were perfectly OK? The answer, it seems to me, is that it would look just like what we’re seeing.

Bear in mind that the whole problem right now is that the private sector is hurting, it’s spooked, and it’s looking for safety. So it’s piling into “cash”, which really means short-term debt. (Treasury bill rates briefly went negative yesterday). Meanwhile, the public sector is sustaining demand with deficit spending, financed by long-term debt. So someone has to be bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue; call it a carry trade if you like, but it’s a normal and necessary thing.

Now, you could and should be worried if this thing looked like a great bubble — if long-term rates looked unreasonably low given the fundamentals. But do they? Long rates fluctuated between 4.5 and 5 percent in the mid-2000s, when the economy was driven by an unsustainable housing boom. Now we face the prospect of a prolonged period of near-zero short-term rates — I don’t see any reason for the Fed funds rate to rise for at least a year, and probably two — which should mean substantially lower long rates even if you expect yields eventually to rise back to 2005 levels. And if we’re facing a Japanese-type lost decade, which seems all too possible, long rates are in fact still unreasonably high.

Still, what about the possibility of a squeeze, in which rising rates for whatever reason produce a vicious circle of collapsing balance sheets among the carry traders, higher rates, and so on? Well, we’ve seen enough of that sort of thing not to dismiss the possibility. But if it does happen, it’s a financial system problem — not a deficit problem. It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized.

And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt. Whatever you do, don’t undermine recovery by calling off jobs creation.

The point is that it’s crazy to let the rescue of the economy be held hostage to what is, if it’s an issue at all, a technical matter of maturity mismatch. And again, it’s not clear that it even is an issue. What the worriers seem to regard as a danger sign — that supposedly awful carry trade — is exactly what you would expect to see even if fiscal policy were on a perfectly sustainable trajectory.

Then DeLong:

I am not sure Paul is correct when he says that the possible underlying problem is merely “a technical matter of maturity mismatch.” The long Treasury market is thinner than many people think: it is not completely implausible to argue that it is giving us the wrong read on what market expectations really are because long Treasuries right now are held by (a) price-insensitive actors like the PBoC and (b) highly-leveraged risk lovers borrowing at close to zero and collecting coupons as they try to pick up nickles in front of the steamroller. And to the extent that the prices at which businesses can borrow are set by a market that keys off the Treasury market, an unwinding of this “carry trade”–if it really exists–could produce bizarre outcomes.

Bear in mind that this whole story requires that the demand curve slope the wrong way for a while–that if the prices for Treasury bonds fall carry traders lose their shirts and exit the market, and so a small fall in Treasury bond prices turns into a crash until someone else steps in to hold the stock…

For reference, here are the time paths of interest rates for a variety of term lengths and risk profiles (all taken from FRED):

interest_rates_1monthinterest_rates_3monthsinterest_rates_30years

To my own mind, I’m somewhat inclined to agree with Krugman.  While I do believe that the carry trade is occurring, I suspect that it’s effects are mostly elsewhere, or at least that the carry trade is not being played particularly heavily in long-dated US government debt relative to other asset markets.

Notice that the AAA and BAA 30-year corporate rates are basically back to pre-crisis levels and that the premium they pay over 30-year government debt is also back to typical levels.  If the long-dated rates are being pushed down to pre-crisis levels solely by increased supply thanks to the carry trade, then we would surely expect the quantity of credit to also be at pre-crisis levels.  But new credit issuance is down relative to the pre-crisis period.  Since the price is largely unchanged, that means that both demand and supply of credit have shrunk – the supply from fear in the financial market pushing money to the short end of the curve and the demand from the fact that there’s been a recession.

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The contradictory joys of being the US Treasury Secretary (part 2)

Published on 16 November 2009 at 4:28 pm in Economics, Finance, Politics, Trade and USA. Tags: , , , , , , , , , , , , .

In my last post, I highlighted the apparent contradictions between the USA having both a “strong dollar” policy and a desire to correct their trade deficit (“re-balancing”).  Tim Geithner, speaking recently in Tokyo, declared that there was no contradiction:

Geithner said U.S. efforts to boost exports aren’t in conflict with the “strong-dollar” policy. “I don’t think there’s any contradiction between the policies,” he said.

I then said:

The only way to reconcile what Geithner’s saying with the laws of mathematics is to suppose that his “strong dollar” statements are political and relate only to the nominal exchange rate and observe that trade is driven by the real exchange rate. But that then means that he’s calling for a stable nominal exchange rate combined with either deflation in the USA or inflation in other countries.

Which, together with Nouriel Roubini’s recent observation that the US holding their interest rates at zero is fueling “the mother of all carry trades” [Financial Times, RGE Monitor], provides for a delicious (but probably untrue) sort-of-conspiracy theory:

Suppose that Tim Geithner firmly believes in the need for re-balancing.  He’d ideally like US exports to rise while imports stayed flat (since that would imply strong global growth and new jobs for his boss’s constituents), but he’d settle for US imports falling.  Either way, he needs the US real exchange rate to fall, but he doesn’t care how.  Well, not quite.  His friend Ben Bernanke tells him that he doesn’t want deflation in America, but he doesn’t really care between the nominal exchange rate falling and foreign prices rising (foreign inflation).

The recession-induced interest rates of (effectively) zero in America are now his friend, because he’s going to get what he wants no matter what, thanks to the carry trade.  Private investors are borrowing money at 0% interest in America and then going to foreign countries to invest it at interest rates that are significantly higher than zero.  If the foreign central banks did nothing, that would push the US dollar lower and their own currencies higher and Tim gets what he wants.

But the foreign central banks want a strong dollar because (a) they’re holding gazzilions of dollars worth of US treasuries and they don’t want their value to fall; and (b) they’re not fully independent of their political masters who want to want to keep exporting.   So Tim regularly stands up in public and says that he supports a strong dollar.  That makes him look innocent and excuses the foreign central banks for doing what they were all doing anyway:  printing local money to give to the US-funded investors so as to keep their currencies down (and the US dollar up).

But that means that the money supply in foreign countries is climbing, fast, and while prices may be sticky in the short term, they will start rising soon enough.  Foreign inflation will lower the US real exchange rate and Tim still gets what he wants.

The only hope for the foreign central banks is that the demand for their currencies is a short-lived temporary blip.  In that case, defending their currencies won’t require the creation of too much local currency and they could probably reverse the situation fast enough afterward that they don’t get bad inflation. [This is one of the arguments in favour of central bank involvement in the exchange-rate market.  Since price movements are sluggish, they can sterilise a temporary spike and gradually back out the action before local prices react too much.]

But as foreign central banks have been discovering [1], free money is free money and the carry trade won’t go away until the interest rate gap is sufficiently closed:

Nov. 13 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.

South Korea Deputy Finance Minister Shin Je Yoon said yesterday the country will leave the level of its currency to market forces after adding about $63 billion to its foreign exchange reserves this year to slow the appreciation of the won.
[...]
Brazil’s real is up 1.1 percent against the dollar this month, even after imposing a tax in October on foreign stock and bond investments and increasing foreign reserves by $9.5 billion in October in an effort to curb the currency’s appreciation. The real has risen 33 percent this year.
[...]
“I hear a lot of noise reflecting the government’s discomfort with the exchange rate, but it is hard to fight this,” said Rodrigo Azevedo, the monetary policy director of Brazil’s central bank from 2004 to 2007. “There is very little Brazil can do.”

The central banks are stuck.  They can’t lower their own interest rates to zero (which would stop the carry trade) as that would stick a rocket under domestic production and cause inflation anyway.  The only thing they can do is what Brazil did a little bit of:  impose legal limits on capital inflows, either explicitly or by taxing foreign-owned investments.  But doing that isn’t really an option, either, because they want to be able to keep attracting foreign investment after all this is over and there’s not much scarier to an investor than political uncertainty.

So they have to wait until America raises it’s own rates.  But that won’t happen until America sees a turn-around in jobs and the fastest way for that to happen is for US exports to rise.

[1] Personally, I think the central bankers saw the writing on the wall the minute the Fed lowered US interest rates to (effectively) zero but their political masters were always going to take some time to cotton on.

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The contradictory joys of being the US Treasury Secretary

Published on 16 November 2009 at 11:45 am in Economics, Finance, Politics, Trade and USA. Tags: , , , , , , , , , .

Tim Geithner, speaking at the start of the G-20 meeting in Pittsburgh:

Sept. 25 (Bloomberg) — Treasury Secretary Timothy Geithner said he sees a “strong consensus” among Group of 20 nations to reduce reliance on exports for growth and defended the dollar’s role as the world’s reserve currency.

“A strong dollar is very important in the United States,” Geithner said in response to a question at a press conference yesterday in Pittsburgh, where G-20 leaders began two days of talks.

Tim Geithner, speaking in Tokyo while joining the US President on a tour of Asian capitals:

Nov. 11 (Bloomberg) — U.S. Treasury Secretary Timothy Geithner said a strong dollar is in the nation’s interest and the government recognizes the importance it plays in the global financial system.

“I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,” Geithner told reporters in Tokyo today.
[...]
Geithner said U.S. efforts to boost exports aren’t in conflict with the “strong-dollar” policy. “I don’t think there’s any contradiction between the policies,” he said.

Which is hilarious.

There is no objective standard for currency strength [1].  A “strong (US) dollar” is a dollar strong relative to other currencies, so it’s equivalent to saying “weak non-US-dollar currencies”.  But when the US dollar is up and other currencies are down, that means that the US will import more (and export less), while the other countries will export more (and import less), which is the exact opposite of the re-balancing efforts.

The only way to reconcile what Geithner’s saying with the laws of mathematics is to suppose that his “strong dollar” statements are political and relate only to the nominal exchange rate and observe that trade is driven by the real exchange rate.  But that then means that he’s calling for a stable nominal exchange rate combined with either deflation in the USA or inflation in other countries.

Assuming my previous paragraph is true, 10 points to the person who can see the potential conspiracy theory [2] implication of Nouriel Roubini’s recent observation that the US holding their interest rates at zero is fueling “the mother of all carry trades” [Financial Times, RGE Monitor].

Hint:  If you go for the conspiracy theory, this story would make you think it was working.

Nov. 13 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.
[...]
Governments are amassing record foreign-exchange reserves as they direct central banks to buy dollars in an attempt to stem the greenback’s slide and keep their currencies from appreciating too fast and making their exports too expensive.
[...]
“It looked for a while like the Bank of Korea was trying to defend 1,200, but it looks like they’ve given up and are just trying to slow the advance,” said Collin Crownover, head of currency management in London at State Street Global Advisors

The answer to follow …

Update: The answer is in my next post.

[1] There better not be any gold bugs in the audience.  Don’t make me come over there and hurt you.

[2] Okay, not a conspiracy theory; just a behind-the-scenes-while-completely-in-the-open strategy of international power struggles.

[1] There better not be any gold bugs on this list.  Don’t make me
come over there and hurt you.

[2] Okay, not a conspiracy theory; just a behind-the-scenes-while-
completely-in-the-open strategy of international power struggles.

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Who has more information, the Central Bank or the Private Sector?

Published on 5 November 2009 at 4:48 pm in Academia, Article Summary, Economics, Finance and Welfare. Tags: , , , , , .

A friend pointed me to this paper:

Svensson, Lars E. O. and Michael Woodford. “Indicator Variables For Optimal Policy,” Journal of Monetary Economics, 2003, v50(3,Apr), 691-720.

You can get the NBER working paper (w8255) here.  The abstract:

The optimal weights on indicators in models with partial information about the state of the economy and forward-looking variables are derived and interpreted, both for equilibria under discretion and under commitment. The private sector is assumed to have information about the state of the economy that the policymaker does not possess. Certainty-equivalence is shown to apply, in the sense that optimal policy reactions to optimally estimated states of the economy are independent of the degree of uncertainty. The usual separation principle does not hold, since the estimation of the state of the economy is not independent of optimization and is in general quite complex. We present a general characterization of optimal filtering and control in settings of this kind, and discuss an application of our methods to the problem of the optimal use of ‘real-time’ macroeconomic data in the conduct of monetary policy. [Emphasis added by John Barrdear]

The sentence I’ve highlighted is interesting.  As written in the abstract, it’s probably true.  Here’s a paragraph from page two that expands the thought:

One may or may not believe that central banks typically possess less information about the state of the economy than does the private sector. However, there is at least one important argument for the appeal of this assumption. This is that it is the only case in which it is intellectually coherent to assume a common information set for all members of the private sector, so that the model’s equations can be expressed in terms of aggregative equations that refer to only a single “private sector information set,” while at the same time these model equations are treated as structural, and hence invariant under the alternative policies that are considered in the central bank’s optimization problem. It does not make sense that any state variables should matter for the determination of economically relevant quantities (that is, relevant to the central bank’s objectives), if they are not known to anyone in the private sector. But if all private agents are to have a common information set, they must then have full information about the relevant state variables. It does not follow from this reasoning, of course, that it is more accurate to assume that all private agents have superior information to that of the central bank; it follows only that this case is one in which the complications resulting from partial information are especially tractable. The development of methods for characterizing optimal policy when di fferent private agents have di fferent information sets remains an important topic for further research.

Here’s my attempt as paraphrasing Svensson and Woodford in point form:

  1. The real economy is the sum of private agents (plus the government, but ignore that)
  2. Complete information is thus, by definition, knowledge of every individual agent
  3. If we assume that everybody knows about themselves (at least), then the union of all private information sets must equal complete information
  4. The Central Bank observes only a sample of private agents
  5. That is, the Central Bank information set is a subset of the union of all private information sets. The Central Bank’s information cannot be greater than the union of all private information sets.
  6. One strategy in simplifying the Central Bank’s problem is to assume that private agents are symmetric in information (i.e. they have a common information set).  In that case, we’d say that the Central Bank cannot have more information than the representative private sector agent. [See note 1 below]
  7. Important future research will involve relaxing the assumption in (f) and instead allowing asymmetric information across different private agents.  In that world, the Central Bank might have more information than any given private agent, but still less than the union of all private agents.

Svensson and Woodford then go on to consider a world where the Central Bank’s information set is smaller than (i.e. is a subset of) the Private Sector’s common information set.

But that doesn’t really make sense to me.

If private agents share a common information set, it seems silly to suppose that the Central Bank has less information than the Private Sector, for the simple reason that the mechanism of creating the common information set – commonly observable prices that are sufficient statistics of private signals – is also available to the Central Bank.

In that situation, it seems more plausible to me to argue that the CB has more information than the Private Sector, provided that their staff aren’t quietly acting on the information on the side.  It also would result in observed history:  the Private Sector pays ridiculous amounts of attention to every word uttered by the Central Bank (because the Central Bank has the one private signal that isn’t assimilated into the price).

Note 1: To arrive at all private agents sharing a common information set, you require something like the EMH (in fact, I can’t think how you could get there without the EMH).  A common information set emerges from a commonly observable sufficient statistic of all private information.  Prices are that statistic.

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    The Nobel committee can’t lose in their decision over Fama

    Published on 9 October 2009 at 3:12 pm in Academia, Betting markets, Economics, Finance and Humour. Tags: , , , .

    Alex Tabarrok points out the amusing truth:

    Ladbrokes gives Eugene Fama the best odds for winning the economics Nobel.  Thus, if Fama wins he will have deserved to have won and if Fama loses he will not have deserved to have won.  The Nobel committee cannot go wrong no matter what it does!  Think about it.

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