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US treasury interest rates and (disin|de)flation

This Bloomberg piece from a few days ago caught my eye.  Let me quote a few hefty chunks from the article (highlighting is mine):

Bond investors seeking top-rated securities face fewer alternatives to Treasuries, allowing President Barack Obama to sell unprecedented sums of debt at ever lower rates to finance a $1.47 trillion deficit.

While net issuance of Treasuries will rise by $1.2 trillion this year, the net supply of corporate bonds, mortgage-backed securities and debt tied to consumer loans may recede by $1.3 trillion, according to Jeffrey Rosenberg, a fixed-income strategist at Bank of America Merrill Lynch in New York.

Shrinking credit markets help explain why some Treasury yields are at record lows even after the amount of marketable government debt outstanding increased by 21 percent from a year earlier to $8.18 trillion. Last week, the U.S. government auctioned $34 billion of three-year notes at a yield of 0.844 percent, the lowest ever for that maturity.
[…]
Global demand for long-term U.S. financial assets rose in June from a month earlier as investors abroad bought Treasuries and agency debt and sold stocks, the Treasury Department reported today in Washington. Net buying of long-term equities, notes and bonds totaled $44.4 billion for the month, compared with net purchases of $35.3 billion in May. Foreign holdings of Treasuries rose to $33.3 billion.
[…]
A decline in issuance is expected in other sectors of the fixed-income market. Net issuance of asset-backed securities, after taking into account reinvested coupons, will decline by $684 billion this year, according to Bank of America’s Rosenberg. The supply of residential mortgage-backed securities issued by government-sponsored companies such as Fannie Mae and Freddie Mac is projected to be negative $320 billion, while the debt they sell directly will shrink by $164 billion. Investment- grade corporate bonds will decrease $132 billion.

“The constriction in supply is all about deleveraging,” Rosenberg said.
[…]
“There’s been a collapse in both consumer and business credit demand,” said James Kochan, the chief fixed-income strategist at Menomonee Falls, Wisconsin-based Wells Fargo Fund Management, which oversees $179 billion. “To see both categories so weak for such an extended period of time, you’d probably have to go back to the Depression.”

Greg Mankiw is clearly right to say:

“I am neither a supply-side economist nor a demand-side economist. I am a supply-and-demand economist.”

(although I’m not entirely sure about the ideas of Casey Mulligan that he endorses in that post — I do think that there are supply-side issues at work in the economy at large, but that doesn’t necessarily imply that they are the greater fraction of America’s macroeconomic problems, or that demand-side stimulus wouldn’t help even if they were).

When it comes to US treasuries, it’s clear that shifts in both demand and supply are at play.  Treasuries are just one of the investment-grade securities on the market that are, as a first approximation, close substitutes for each other.  While the supply of treasuries is increasing, the supply of investment-grade securities as a whole is shrinking (a sure sign that demand is falling in the broader economy) and the demand curve for those same securities is shifting out (if the quantity is rising and the price is going up and supply is shifting back, then demand must also be shifting out).

Paul Krugman and Brad DeLong have been going on for a while about invisible bond market vigilantes, criticising the critics of US fiscal stimulus by pointing out that if there were genuine fears in the market over government debt, then interest rates on the same (which move inversely to bond prices) should be rising, not falling as they have been.  Why the increased demand for treasuries if everyone’s meant to be so afraid of them?

They’re right, of course (as they so often are), but that’s not the whole picture.  In the narrowly-defined treasuries market, the increasing demand for US treasuries is driven not only by the increasing demand in the broader market for investment-grade securities, but also by the contraction of supply in the broader market.

It’s all, in slow motion, the very thing many people were predicting a couple of years ago — the gradual nationalisation of hither-to private debt.  Disinflation (or even deflation) is essentially occurring because the government is not replacing all of the contraction in private credit.

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What effect does a change in interest rates have on today’s consumption?

A common, even standard, way of thinking about the effect of interest rates on household decisions is to suppose that consumption tomorrow is just another “good” that the household may choose to spend money on today, it’s price being 1/(1+r) where r is the real interest rate (so if r = 5%, then to buy $1 in tomorrow’s dollars, it will “cost” you $0.9523 today).  In that framework, an increase in the (real) interest rate will lower the price of consumption tomorrow relative to the various goods on offer today and households will consequently shift some of their income to savings.  An increase in interest rates increases savings and lowers consumption today.  Obvious, right?

That brings me to this article on Bloomberg today.  Here are the first three paragraphs:

Peking University professor Michael Pettis was discussing declining bank-deposit returns when a student interrupted with a story about her aunt that may stymie China’s plan to boost consumer spending.

“To send her son to university in six years it means she must replace each yuan in lost income with one from her wages,” the student said, according to Pettis.

The government’s policy of keeping interest rates low to reduce the burden of soaring municipal debt is costing savers as much as 1.6 trillion yuan ($236 billion) a year in lost income on bank deposits, according to Pettis, former head of emerging markets at Bear Stearns Cos. To make up the shortfall, savers have to set aside a larger proportion of wages, undermining China’s efforts to counter slower export growth with consumer spending at home.

This is essentially saying that savings can act as a type of Giffen good — one for which consumers increase the quantity demanded when it’s price increases — when households take a future spending constraint into account today.  When you know that you must have at least $x set aside tomorrow, an increase in the interest rate lowers the minimum amount of savings required today to meet the target.  If that lower bound on savings was binding (i.e. without the future constraint you’d have preferred to spend more today) before the change, then higher interest rates will lead to a decrease in savings and an increase in consumption today.

To get this, we need is some (edit: non-divisible) future spending commitment that for some reason can’t be paid for with future income — two simple examples would be saving for retirement or, in America, for the university tuition of your children when they will be credit-constrained — and sufficient forward planning on the part of households so as to take it into account today.  Both seem plausible for a large fraction of households.

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Paying interest on (excess) reserves (Updated)

The U.S. Federal Reserve is currently paying 0.25% interest on the reserve accounts of depository institutions.  This is therefore, at present, the primary rate of policy concern (as opposed to the Fed Funds rate):  if a bank can’t get a rate of return that, when adjusted for risk, is greater than 0.25%, they will stick their money in their reserve account at the Fed.  Among others, Scott Sumner [blog] has called this policy a mistake.

There is an economic cost to the policy.  0.25% isn’t much, but it’s the risk-free aspect that complicates things.  If banks’ risk aversion or their perception of the risks associated with investments are high, then a truely risk-free 0.25% could look quite attractive.  With the interest rates on US treasuries so low, there’s certainly reason to believe that risk aversion is still abnormally high at the moment.  Whether the demand for loans is coming from particularly risky projects, or is perceived to be, I don’t know (is there any way of knowing?).

So why have it at all?  I suppose I support the paying of interest on required reserves.  The banks don’t get a choice with them, so it seems only fair that they be compensated.  But for excess reserves, there would need to be an offsetting benefit to justify the policy.  One benefit will be that the interest is paid with new money, so it’s a way of quietly helping banks improve their balance sheets.  There’s currently about US$1 trillion in excess reserves, so that’s about US$2.5 billion per year.  That may be a lot of money to you and me, but it’s not much more than a rounding error to the US banking system as a whole.  Still, it’s something.  Another benefit, depending on your point of view, is that by attracting all that money into excess reserves, the Fed sterilised the QE they engaged in last year.  If you feel that the sterilised QE has caused lower long-term interest rates and hold that those rates are the ones that most significantly drive the economy and distinctly dislike inflation, then you’d probably judge the affair to have been a success [I include the weasel words because I am no longer certain].  A third benefit, which is really a further justification of the second, is that there is evidence that the Fed’s QE appears to have lowered not just US rates, but foreign rates as well.  In that case, then you probably want to sterilise the fraction going to other countries (bad enough, one might think, that America is fixing the rest of the world; it would be unthinkable if America also had to suffer inflation by doing so).

Anyway, all of that is by way of getting around to this point:  via Bruce Bartlett, I’ve just discovered that Sweden also pays interest on reserve deposits, normally 0.75 percentage points lower than their repo rate.  But, crucially, their repo rate is currently only 0.50%, which means that their deposit rate is negative, at -0.25%.

For myself, I tend to think that the interest rate on excess reserves should be lowered.  My argument is similar to what I imagine Scott Sumner would say, so I should also explain his view a little, to the extent that I understand him.  With nominal GDP at US$14 trillion, the US$1 trillion sitting in excess reserves is a very, very large amount of money.  If it were released into the economy, it would be a huge stimulus (even if the money multiplier/velocity of money is temporarily low).  By choosing to sterilise their QE (presumably out of fear of inflation), the Fed has turned what could have been a tremendously effective stimulus into a mediocre one at best.  Scott is rather more sanguine about inflation in general than I am (he favours targeting NGDP; I suspect that this graph would make him want to tear his hair out), but even if the Fed wishes to target inflation of, say, the near-universally accepted benchmark of 2%, then with actual current inflation down at 0.5% and expected future inflation below 1.5% for most of the next 10 years and falling, the sterilisation has been excessive.

Update 6 Aug 2010:

The FT’s Alphaville has gathered the arguments for and against.  Here are three arguments (and their counter-arguments) for keeping the Interest on Reserves (IoR) unchanged:

First, from Ben Bernanke himself, made in recent congressional testimony:

The rationale for not going all the way to zero has been that we want the short-term money markets like the federal funds market to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system, and if that market shuts down … it’ll be more difficult to manage short-term interest rates, for the Federal Reserve to tighten policy sometime in the future. So there’s really a technical reason having to do with market function that motivated the 25 basis points interest on reserves.

I think this is silly. It’ll be more difficult to manage short-term interest rates in the future only if, following an effective shut-down of the federal funds market, it becomes costly to start it back up again. I seriously doubt that the banks are going to take their existing staff, processes and infrastructure dedicated to this and throw them out the window. Heck, in a Q&A session after his testimony, Mr Bernanke stated that lowering the interest rate on reserves is a (serious) option in the event that the FMOC decides that further stimulus is warranted:

But broadly speaking, there are a number of things we could consider and look at; one would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time — giving more information about that, that’s certainly one approach. We could lower the interest rate we pay on reserves, which is currently one-fourth of 1%.

A second viewpoint, put forward by Dave Altig (of the Atlanta Fed) and Joseph Abate (of Barclays Capital), is that

If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.

I think that Jim Hamilton’s response to this is excellent, so let me just quote it in full:

But Dave doesn’t quite finish the story. If I as an individual bank decide that a repo or T-bill looks better than zero, and use my excess reserves to buy one of these instruments, I simply instruct the Fed to transfer my deposits to the bank of whoever sold it to me. But now, if that bank does nothing, it would be left with those reserve balances at the end of the day on which it earns nothing, whereas it, too, could instead get some interest by going with repos or T-bills. The reserves never get “shifted into short-term, low-risk markets”– instead, by definition, they are always sitting there, at the end of the day, on the balance sheet of some bank somewhere in the system.

The implicit bottom line in the Abate story is that the yields on repos and T-bills adjust until they, too, look essentially to be zero, so that banks in fact don’t care whether they leave a trillion dollars earning no interest every day.

The essence of this world view is that there are two completely distinct categories of assets– cash-type assets which pay no interest whatever, and risky investments like car loans that banks don’t want to make no matter how much cash they hold.

But I really have trouble thinking in terms of such a two-asset world. I instead see a continuum of assets out there. As a bank, I could keep my funds overnight with the Fed, I could lend them in an overnight repo, I could buy a 1-week Treasury, a 3-month Treasury, a 10-year Treasury, or whatever. Wherever you want to draw a line between available assets and claim those on the left are “cash” and those on the right are “risky”, I’m quite convinced I could give you an example of an asset that is an arbitrarily small epsilon to the right or the left of your line. Viewed this way, I have a hard time understanding how pushing a trillion dollars at the shortest end of the continuum by 25 basis points would have no consequences whatever for the yield on any other assets.

Finally, back with Dave Altig, there is the argument that:

the IOR policy has long been promoted on efficiency grounds. There is this argument for example, from a New York Fed article published just as the IOR policy was introduced:

“… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

“… it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank.”

Put more simply, one broad justification for an IOR policy is precisely that it induces banks to hold quantities of excess reserves that are large enough to mitigate the need for central banks to extend the credit necessary to keep the payments system running efficiently. And, of course, mitigating those needs also means mitigating the attendant risks.

But, to me, this really sounds like an argument for having higher reserve requirements, not an argument for encouraging excess reserves.  I’m all for paying interest on required reserves and setting the fraction required at whatever level you judge necessary to ensure the operation of the payments system.  But don’t try to shoe-horn that argument into keeping interest payments on excess reserves.

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The perverse incentives of Queensland traffic law

In the Australian state of Queensland, a violation of traffic law is punished by a fine and the awarding of points.  Points for a conviction stay on your licence for three years.  If you ever have 12 points at the same time, you’re in trouble.  I’ll come to that in a moment.

Somebody I know, let’s call him Semaj, has recently got himself up to 11 points.  He doesn’t dispute that he broke the law for all of them; he did.  Most of them came from speeding, but the last three points came from driving through a yellow light.  In Queensland, just like everywhere else on the planet, you must stop at a red light; but for a yellow light, you must stop if you are safely able to do so.  Some people believe that the yellow light should just be to warn drivers that the red is coming and have no penalty tied to it, but that’s not what I want to focus on.  To really rub salt in the wound, the light was still yellow when Semaj left the intersection and the only other car in the area was that of the police officer that booked him.  That’s what those in the business call a “dick move” by the cop, but it’s not what I want to focus on either.  What I want to focus on is …

***

Perverse incentive #1

The punishment for not stopping for a yellow light when you were safely able to is the same as that for not stopping at a red light:  AU$300 and 3 points.  This is absurd, because it fails to make the punishment proportionate to the severity of the crime.  By doing so, the government offers an incentive to people to treat them as equivalent.  To illustrate the point, let me take the idea embedded here in Queensland law to a logical, but ridiculous conclusion:

The violation of all laws should be punishable by the same penalty. A serial rapist-murderer should be locked away for life. Therefore, overstaying your parking for just one minute should lead to your being locked away for life.

See?  Absurd.  Clearly there are gradations of severity and, just as clearly, there should be corresponding gradations of punishment.  If the punishment for running a red light is a fine and 3 points, then the punishment for running a yellow should be a smaller fine and 1 point.

***

Anyway.  Moving on.  Semaj now has 11 points on his licence.  The oldest of his points is only one year old, so he has two full years before any of them are removed.  If he gets even a single point over the next two years, he will be faced with the following choice when he turns up at the Department of Transport to pay his fine:

  • either give up his licence for three months;
  • or go on a probationary licence (with a limit of two points instead of 12) for a full year.

After this, he will be returned a regular full licence entirely clear of points.  Hopefully you can now see …

***

Perverse incentive #2

Semaj is in a position where he would be better off by breaking the law.  The government is giving him an incentive to break the law.  If Semaj follows the law, he will have a one-point buffer for two years, then a three-point buffer for a year before returning to a full licence.  That’s three years in total.  If he deliberately gets caught for a one point infraction tomorrow, he can have a two-point buffer for one year and then go immediately to a full licence.  The cost to him will just be the fine for tomorrow’s infraction; maybe $100.

Who wouldn’t take that option?  It’s crazy.  If you’re going to have a point system with the possibility of a probationary licence, then the length of the probationary period should be long enough that someone in Semaj’s position wouldn’t actually prefer to be on it.

***

As I’ve said before, I believe that all fines issued for misdemeanours should not be for a fixed amount, but for a percentage of the transgressor’s income. When faced with the prospect of a $400 fine, somebody earning $20,000 a year will pay attention, but somebody earning $200,000 will not care nearly as much.  The two people therefore face different incentives when it comes to obeying the law.

Of course, none of this comes close for the most ridiculous traffic law in Queensland.  That most dubious of prizes goes to this piece of nanny-state-run-amok trash:  Drivers on P-plates (that’s a “provisional” licence) “under 25 years of age can only carry one passenger under the age of 21 years who is not an immediate family member, when driving between 11pm on a day and 5am on the next day.”

For reference, the very earliest that somebody in Queensland can move from a provisional to a full licence is at the age of 20.  That is two or three years into university.  Most Queenslanders, if they go to university and don’t take a gap year, would turn 21 in their fourth year.

The “peer passenger restriction” of provisional licences is designed to prevent distraction (from drunk louts in the back seat) to the driver and so, presumably, lead to fewer accidents and thus fewer fatalities.  Whether it ultimately succeeds in reducing road deaths is an empirical question.  I don’t have access to the data, but to my mind there’s a fair possibility that we’ll actually see more road deaths from this, because …

***

Perverse incentive #3

By forcing university-age people to not share a car, the Queensland government is:

  • abandoning the idea of a designated driver; and
  • encouraging more traffic onto the roads at just the time of day when people are least likely to pay full attention to the road (what, did they think that those kids would stay home?).

Both of those effects will serve to push up the accident (and thus, fatality) rates.

If you want to keep drunk 20-year-olds off the roads, then give them a way to avoid them.  Improve public transport.  Lift the licencing restrictions on taxis.

***

Idiots.

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America and health care

In the light of the recent passage by the U.S. House of Represenatives of the Senate’s version of healthcare reform and the ensuing wailing, gnashing of teeth and smearing of soot in the hair by opponents of said reform, let me give my view – as an outsider – on the matter:

It’s a question of morality.

It astounds me — and, frankly, every other non-American USA-watcher in the developed world — that the richest nation on earth, whose very constitution proclaims the pursuit of life, liberty and happiness to be it’s highest ideals, whose citizenry so loudly profess to live by Christian virtues, would not guarantee that some form of basic, minimum healthcare be available to all of its citizens independently of their ability to pay.  It utterly astounds me.  If I were American, it would disgust me that this had not happened 50 years ago.

If my income and my wealth is above average for my society, I have an ethical duty to subsidise the health care of those who are, for whatever reason, at the lower end of the spectrum.  Yes, there are issues of free riders and of personal responsibility, but they simply do not matter when answering the basic question.  The government of a country, acting on behalf of that country’s people, has a moral imperative to provide a minimum level of care to all of its citizens.

I am not saying this as a screaming socialist.  I freaking hate socialism.  I love the market (when it’s allowed to function properly with full transparancy).  I support (at least partially, and possibly fully) privitised social security.  I like the idea of small government.  I rage against the nanny-state in Australia and in the UK.  I worry about encouraging dependency and a sence of entitlement in those people assisted by the government.  But those concerns take a back seat on this issue.

So, yes, the second question (a two-for) is to ask what the minimum level should be and how to pay for it.  But first question should have been a no-brainer.

If all the country can afford is a polio shot and a packet of aspirin, then that’s what they should provide (hopefully a charity or two might help out, too).  But if the country is the richest in the history of the planet, they should be able to stump up for a bit more.

And, yes, for the next criticism, this particular reform by the U.S. Congress is nominally promising more than it will reallly provide when it comes to the fiscal deficit.  Yes, again, given America’s political structure, U.S. government spending won’t be truely corrected until there is a real crisis approaching (as opposed to the make-believe crises being proclaimed by people opposed to the bailouts and stimulus package(s)).

I don’t care.  The child of an unemployed, drug-taking high-school dropout should not be deprived of basic access to a doctor just because we’re angry at their parents.  Nor should their parents, come to that.

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Political comic strips around the Mississippi Bubble of the 1710s

I wish that I had time to read this paper by David Levy and Sandra Peart.

It’s about political comics (cartoons) drawn to depict John Law and the Mississippi Bubble of the early 1700s.  It also speaks to subtlely different meanings of the words “alchemy” and “occult” than we are used to today. Here is an early paragraph in the paper:

Non-transparency induces a hierarchy of knowledge. The most extreme form of that sort of hierarchy might be called the cult of expertise in which expertise is said to be accompanied by godlike powers, the ability to unbind scarcity of matter and time. The earliest debates over hierarchy focused on whether such claims are credible or not.

Here is the abstract:

Economists have occasionally noticed the appearance of economists in cartoons produced for public amusement during crises. Yet the message behind such images has been less than fully appreciated. This paper provides evidence of such inattention in the context of the eighteenth century speculation known as the Mississippi Bubble. A cartoon in The Great Mirror of Folly imagines John Law in a cart that flies through the air drawn by a pair of beasts, reportedly chickens. The cart is not drawn by chickens, however, but by a Biblical beast whose forefather spoke to Eve about the consequences of eating from the tree of the knowledge. The religious image signifies the danger associated with knowledge. The paper thus demonstrates how images of the Mississippi Bubble focused on the hierarchy of knowledge induced by non-transparency. Many of the images show madness caused by alchemy, the hidden or “occult.”

Hat tip: Tyler Cowen.

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Thinking about Human Rights (and UNICEF)

Before I begin:  UNICEF has a campaign in the UK at the moment to raise awareness of children being denied their rights around the world.  You can see the homepage for the campaign here.  You can donate here.

Here are some things to keep in mind when thinking about human rights:

  • A right is a particular form of liberty.  It is the freedom to do something.
  • An obligation or mandate is the opposite of a right.  A right involves a conscious choice; thus the phrase “to exercise one’s right.”  If there is no choice available, there is no right.
  • One person having a right often implies denying another right from a second person.  Suppose that you work for me.  If I have the right to fire you, you cannot have the right to a guaranteed job with me.  If you have the right to go on strike, I cannot have the right to fire you for going on strike.
  • Sometimes having a right does not impede the rights of others.  A right to make use of a non-rival good is the classic example.
  • Exercising a right is not necessarily in a person’s best interest.  I have the right to gamble all of my money at a casino, but it probably wouldn’t be wise to do so.
  • Every decision of consequence for everybody, everywhere, is subject to a constraint of some kind.  There are only 24 hours in a day, the resources at your disposal are finite and, eventually, you will die.
  • If a person, operating under a constraint, chooses to not do something, it does not imply that their right has been denied to them.

These last two points, while logical, create problems for many advocacy groups.  Consider the woman who, subject to constraints in her finances and the wages on offer for various jobs she can perform, chooses to become a prostitute.  Consider the subsistence-farming family that, subject to constraints in it’s finances and the wages on offer for alternative work, chooses to keep it’s children away from school and working on the farm.

It is largely for this reason that many people advocate what they call “economic rights”.  Although there are various versions of this (e.g. minimum wages, the welfare state, etc.), you can think of them as a government, on behalf of the entire population, instituting a guaranteed minimum income.

Now, while there are strong moral arguments for such a guarantee (which I fully support and agree with), this is not a right.  This is a mandated transfer of income from high-income citizens to low-income citizens.  For the rich, it is an obligation (the opposite of a right) and for the poor, it does not directly increase the range of choices available to them.  Instead, it indirectly increases that range by relaxing one of their constraints.

I say again:  I fully support providing a minimum income to all people by means of a welfare state; nobody should live in poverty.  But this is not a right.  It is a moral duty.  Calling this an “economic right” is a deliberate obfuscation for marketing purposes.  People pay more attention and money when a person’s “rights” are being denied than when they simply have a moral obligation to help.

I love the work done by UNICEF. I think they are just about the best NGO on the planet. My wife and I donate money to them. They make an express point of telling you how much of the money you give will go to administration costs or to more fundraising.

I just wish they could raise those funds without confusing things by saying that Aklima’s right to education is being denied to her.  I recognise that they have to.  I just wish that they didn’t.

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Double-yolk eggs, clustering and the financial crisis

I happened to be listening when Radio 4’s “Today Show” had a little debate about the probability of getting a pack of six double-yolk eggs.  Tim Harford, who they called to help them sort it out, relates the story here.

So there are two thinking styles here. One is to solve the probability problem as posed. The other is to apply some common sense to figure out whether the probability problem makes any sense. We need both. Common sense can be misleading, but so can precise-sounding misspecifications of real world problems.

There are lessons here for the credit crunch. When the quants calculate that Goldman Sachs had seen 25 standard deviation events, several days in a row, we must conclude not that Goldman Sachs was unlucky, but that the models weren’t accurate depictions of reality.

One listener later solved the two-yolk problem. Apparently workers in egg-packing plants sort out twin-yolk eggs for themselves. If there are too many, they pack the leftovers into cartons. In other words, twin-yolk eggs cluster together. No wonder so many Today listeners have experienced bountiful cartons.

Mortgage backed securities experienced clustered losses in much the same unexpected way. If only more bankers had pondered the fable of the eggs.

The link Tim gives in the middle of my quote is to this piece, also by Tim, at the FT.  Here’s the bit that Tim is referring to (emphasis at the end is mine):

What really screws up a forecast is a “structural break”, which means that some underlying parameter has changed in a way that wasn’t anticipated in the forecaster’s model.

These breaks happen with alarming frequency, but the real problem is that conventional forecasting approaches do not recognise them even after they have happened. [Snip some examples]

In all these cases, the forecasts were wrong because they had an inbuilt view of the “equilibrium” … In each case, the equilibrium changed to something new, and in each case, the forecasters wrongly predicted a return to business as usual, again and again. The lesson is that a forecasting technique that cannot deal with structural breaks is a forecasting technique that can misfire almost indefinitely.

Hendry’s ultimate goal is to forecast structural breaks. That is almost impossible: it requires a parallel model (or models) of external forces – anything from a technological breakthrough to a legislative change to a war.

Some of these structural breaks will never be predictable, although Hendry believes forecasters can and should do more to try to anticipate them.

But even if structural breaks cannot be predicted, that is no excuse for nihilism. Hendry’s methodology has already produced something worth having: the ability to spot structural breaks as they are happening. Even if Hendry cannot predict when the world will change, his computer-automated techniques can quickly spot the change after the fact.

That might sound pointless.

In fact, given that traditional economic forecasts miss structural breaks all the time, it is both difficult to achieve and useful.

Talking to Hendry, I was reminded of one of the most famous laments to be heard when the credit crisis broke in the summer. “We were seeing things that were 25-standard deviation moves, several days in a row,” said Goldman Sachs’ chief financial officer. One day should have been enough to realise that the world had changed.

That’s pretty hard-core.  Imagine if under your maintained hypothesis, what just happened was a 25-standard deviation event.  That’s a “holy fuck” moment.  David Viniar, the GS CFO, then suggests that they occurred for several days in a row.  A variety of people (for example, Brad DeLong, Felix Salmon and Chris Dillow) have pointed out that a 25-standard deviation event is so staggeringly unlikely that the universe isn’t old enough for us to seriously believe that one has ever occurred.  It is therefore absurd to propose that even a single such event occurred.   The idea that several of them happened in the space of a few days is beyond imagining.

Which is why Tim Harford pointed out that even after the first day where, according to their models, it appeared as though a 25-standard deviation event had just occurred, it should have been obvious to anyone with the slightest understanding of probability and statistics that they were staring at a structural break.

In particular, as we now know, asset returns have thicker tails than previously thought and, possibly more importantly, the correlation of asset returns varies with the magnitude of that return.  For exceptionally bad outcomes, asset returns are significantly correlated.

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Note to self: holidaying in Greece will soon be cheap

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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Today’s must read: Russian economic development, as seen through McDonalds

Go here, at the NY Times, and read the article now.  I’ll give a few tiny snippets to whet your appetite, but you really do need to read the whole thing:

Today, private businesses in Russia supply 80 percent of the ingredients in a McDonald’s, a reversal from the ratio when it opened in 1990 and 80 percent of ingredients were imported.
[…]
From the day it opened the gates on the $50 million factory, McDonald’s had intended to hand out its functions to other businesses and eventually shut it down, said Khamzat Khasbulatov, the director of McDonald’s in Russia.

Arms-length transactions for supplies allow McDonald’s to step back from the interaction of franchisees and food-processing companies, sparing them a headache. Russia’s 235 restaurants have not yet been franchised.

“We knew from Day 1 that our goal was to outsource all its functions,” Mr. Khasbulatov said.

Today the restaurants in Russia employ 25,000 people, a number far eclipsed by the businesses in McDonald’s supply chain, which employ 100,000, Mr. Khasbulatov said.

That is successful economic development.  Right there.