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Terrible news from Apple (AAPL)

Apple just reported their profits for 2011Q4.  It turns out that they made rather a lot of money.  So much, in fact, that they blew past/crushed/smashed expectations as their profit more than doubled on the back of tremendous growth in sales of iPhones and iPads.  [snark] I’ll bet nobody’s talking about Tim Cook being gay now. [/snark]

It’s an incredible result; stunning, really. I just wish it didn’t make me so depressed.

I salute the innovation and cheer on the profits. That is capitalism at its finest and we need more of it.

It’s that f***king mountain of cash (now up to $100 billion) that concerns me, because it’s symptomatic of what is holding America (and Britain) in the economic doldrums.

The return Apple will be getting on that cash will be miniscule, if it’s positive at all, and conceivably negative.  Standing next to that, their return on assets excluding cash is phenomenal.

Why aren’t they doing something with the cash? Are they not able to expand profits still further by expanding quantities sold, even in new markets? Are there no new internal projects to fund? No competitors to buy out? Why not return it to shareholders via dividends or share buybacks?

Logically, a company holds cash for some combination of three reasons: (a) they use it to manage cash flow; (b) they can imagine buying an outside asset (a competitor or some other company that might complement them) in the near future and they want to be able to move quickly (and there’s no M&A deal that’s agreed upon faster than an all cash deal); or (c) they want to demonstrate a degree of security to offset any market perceived risk with their debt.

Apple long ago surpassed all of these benefits.  The net marginal value of Apple holding an extra dollar of cash is negative because it returns nothing and incurs a lost opportunity cost.  So why aren’t their shareholders screaming at them for wasting the opportunity?

The answer, so far as I can see, is because a significant majority of AAPL’s shareholders are idiots with a short-term focus. They have no goddamn clue where else the money should be and they’re just happy to see such a bright spot in their portfolio.  Alternatively, maybe the shareholders aren’t complete idiots — Apple’s P/E ratio has been falling for a while now — but the fundamental point is that they have a mountain of cash that they’re not using.

In 2005 that wouldn’t have been as much of a problem because the shadow banking system was in full swing, doing the risk/liquidity/maturity transformation thing that the financial industry is meant to do and so getting that money out to the rest of the economy.[*] Now, the transformation channel is broken, or at least greatly impaired, and so nobody makes any use of Apple’s billions. They just sit there, useless as f***, while profitable SMEs can’t raise funds to expand and 15% of all Americans are on food stamps.

Don’t believe me?  Here’s a graph from the Bank of England showing year-over-year changes in lending to small- and medium-sized enterprises in the UK.  I can’t be bothered looking for the equivalent data for the USA, but you can rest assured it looks similar.  The report it’s from can be found here (it was published only a few days ago).  The Economist’s Free Exchange has some commentary on it here (summary:  we’re still in trouble).

So what is happening to all that money?  Well, Apple can’t exactly stick it in a bank account, so they repo it, which is a fancy way of saying that they lend it to a bank (or somebody else in the financial industry) and temporarily take some high quality asset like a US government bond to hold as collateral.  They repo it because that’s all they can do now — there are no AAA-rated, actually safe, CDO tranches being created by the shadow banking system any more, they’re too big to make use the FDIC’s guarantee (that’s an excellent paper, btw … highly recommended) and so repo is all they have left.

But the financial industry is stuck in a disgusting mess like some kid’s hair with chewing gum rubbed through it. They’re all just as scared as the next guy (especially of the Euro problems) and so they’re parking it in their own accounts at the Fed and the BoE.  As a result, “excess” reserves remain at astronomical levels and the real economy makes no use of Apple’s billions.

That’s a tragedy.

 

 

 

[*] Yes, the shadow banking industry screwed up. They got caught up in real estate fever and sent (relatively) too much money towards property and too little towards more sustainable investments. They structured things in too opaque a manner, failed to have public price discovery and operated under distorted incentives. But they operated. Otherwise useless cash was transformed into real investment and real jobs. Unless that comes back, America and the UK will stay in their slow, painful household deleveraging cycle for another frickin’ decade.

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It’s not a fiscal union and Cameron didn’t veto it

A fiscal union would have transfers from various parts of the union to various other parts over the business cycle.  A guarantee to stand behind somebody’s debt while simultaneously insisting that you’ll never actually need to cough up a cent because you’ve made them pinky swear is not a fiscal union.

A veto stops a thing from happening (think of the UN Security Council).  The fiscal compact is going to go ahead, just without Britain.  Therefore, Britain did not veto it; they declined to take part.

That is all.

Update:

Okay, that isn’t quite all.  Just to be clear, I think that Cameron did the wrong thing.  I believe that, at a minimum, he should have committed to bringing the proposal to the UK parliament.  It may well have been voted down at that point, but nevertheless it should have happened.  Parliament is sovereign in the UK.  This was a serious proposal with potentially significant consequences from either agreeing to it or walking away from it; the people of Britain deserved to have their elected representatives decide.

I am undecided on whether signing up to the pact would be in the best interests of the UK.

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Policy options for the Euro area [Updated]

I here list a few policy options for the Euro area that I support, broadly in descending order of my perception of their importance.  Everything here is predicated on an assumption that the Euro itself is to survive and that no member nation of the Euro area is to exit the union.  I don’t claim that this would solve the crisis — who would make such a claim? — but they would all be positive steps that increase the probability of an ultimate solution being found.

  • Immediately establish a single, Euro area-wide bank deposit guarantee scheme.  A single currency must absolutely ensure that a Euro held as money in Greece be the same as a Euro held as money in Germany.  That means that retail and commercial deposits in each should be backed by the same guarantee.  I have no firm opinion on how it should be funded.  The classic manner is through a fee on banks proportional to their deposits, but if Euro area countries ultimately prefer to use a Tobin-style tax on transactions, that’s up to them.  Just get the thing up and running.  Of course, a unified deposit guarantee also requires a unified resolution authority in the event of an insolvent bank collapsing.  There are many and varied forms that fiscal union can take; this is the most urgent of them all.  I am shocked that this does not already exist.
  • The ECB should switch from targetting current inflation to expected future inflation.  The Bank of England already does this.  Accepting that any effect of monetary policy on inflation will come through with a lag (or at least acknowledging that current inflation is backward looking), they “look through” current inflation to what they expect it to be over the coming few years.  This is important.  Current inflation in the Euro area — i.e. the rate of change over the last 12 months — is at 3%.  On the face of it, that might make an ECB policymaker nervous, but looking ahead, market forecasts for average inflation over the coming five years are as low as 0.85% per year in Germany.  They will be much lower for the rest of the Euro area.  Monetary policy in the Euro area is much, much too tight at the moment.  At the very least, (a) interest rates should be lowered; and (b) the ECB should announce their shift in focus toward forward inflation.
  • The ECB should start to speak more, publicly, about forms of current inflation that most affect future inflation.  This follows on from my previous point, but is still logically distinct.  The Fed likes to focus on “core” inflation, stripped of items with particularly volatile price movements.  I don’t much care whether it is non-volatile prices or nominal wages, or even nominal GDP.  I just want the ECB to be speaking more about something other than headline CPI, because it is those other things that feed into future headlines.
  • The ECB’s provision of liquidity to the banking system, while currently large, is not nearly large enough.  The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this.  I currently have no opinion on whether this ought to be in the form of increasing the duration of loans to Euro area banks, relaxing the collateral requirements for loans or working with member countries’ treasuries to increase the provision of collateral.  I certainly believe (see my second point above) that interest rates should be lowered.  The point, as far as is possible, is to make replacing lost market funding with ECB funding more attractive to banks than deleveraging.
  • A great deal of Euro area sovereign debt is unsustainable; hair-cuts are inevitable and they should be imposed as soon as possible (but, really, this requires that a unified bank resolution authority be established first).  The argument for delaying relies on banks’ ability to first build up a cushion of capital through ongoing profitability.  When banks are instead deleveraging, the problem is made worse by waiting.
  • Credit Default Swaps must be permitted to trigger.  The crisis may have its origins in the the profligacy of wayward sovereigns (frankly, I think the origins lie in the Euro framers not appreciating the power of incentives), but the fundamental aspect of the crisis itself is that various financial assets, previously regarded as safe, are coming to be thought of as risky.  By denying market participants the opportunity to obtain insurance, Euro area policymakers are making the problem worse, not better.  Market willingness to lend to Greece in 2025 will in no way depend on how we label the decisions made in 2011 and 2012.
  • Every member of the Euro periphery should be in an IMF programme.  Yes, I’m looking at you, Italy.  If the IMF does not have sufficient funds to work with, the ECB should lend to it.  All politicians in Euro periphery countries should be speaking to their electorates about multi-decade efforts to improve productivity.  These things cannot be fixed in two or three years.  They can, at best, be put on the right path.
  • For every country in an IMF programme, all sovereign debt held by the ECB should be written down to the price at which they purchase it.   If the ECB buys a Greek government bond at, say, a 20% discount to face value, then that bond should be written down by 20%.  The ECB should not be in a position to make a profit from their trading if Europe finds its way through the overall crisis.  Similarly, the ECB should not be in a position to take a loss, either — they should not be required to take a hair-cut below the price they pay for Euro area sovereign debt.

Note that I have not yet used the phrase “Euro bond” anywhere.  Note, too, that a central bank is only meant to be a lender of last resort to banks.  The lender of last resort to governments is the IMF.

If Euro area policymakers really want to engage in a fiscal union (a.k.a. transfers) beyond the absolutely essential creation of a unified bank deposit guarantee scheme, it is perfectly possible to do so in a minimal fashion that does not lessen the sovereignty of any member nation:  Have a newly created European Fiscal Authority (with voluntary membership) provide the minimum universally agreed-on level of unemployment benefits across the entire area, funded with a flat VAT.  Any member country would retain the ability to provide benefits above and beyond the minimum.  This will have several benefits:

  • Since its membership would be voluntary and it would provide only the minimum universally agreed level, it cannot, by definition, constitute a practical infraction on sovereignty;
  • It will help provide pan-European automatic stabilisers in fiscal policy;
  • It will provide crucial intra-European stabilisation;
  • It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high; and
  • It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

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Update 30 Nov 2011, 13:05 (25 minutes after first publishing the post):

It would appear that the world’s major central banks have announced a coordinated improvement in the provision of liquidity to banks.  This is a good thing. Press releases:

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On the limits of QE at the Zero Lower Bound

When engaging in Quantitative Easing (QE) at the Zero Lower Bound (ZLB), central banks face a trade-off: If they are successful in reducing interest rates on long-term, high-risk assets, they do so at the cost of lowering the profitability of financial intermediaries, making it more difficult for them to repair any balance sheet problems and rendering them more susceptible to future shocks, thereby increasing the fragility of the financial system.

The crisis of 2007/2008 and the present Euro-area difficulties may both be interpreted, from a policymaker’s viewpoint, as a combination of two related events: an exogenous change in the relative supplies of high- and low-risk assets and, subsequently, a classic liquidity crisis. A group of assets that had hitherto been considered low risk suddenly became viewed as high risk. The increased supply of high-risk assets pushed down their price, while the opposite occurred in the market for low-risk assets. Unsure of their counterparties’ exposure to newly-risky assets, the suppliers of liquidity then withdrew their funding. Note that we do not require any change in financial intermediaries’ risk-aversion (their risk appetite) in this story. Tightening credit standards, common to any downturn, serve only to amplify the underlying shock.

Central banks responded admirably to the liquidity crises, supplying unlimited quantities of the stuff and generally at Bagehot’s recommended “penalty rate”. In response to the first problem, and being concerned primarily with effects on the real economy, central banks initially lowered overnight interest rates, trusting markets to correspondingly reduce low-risk and, in turn, high-risk rates. When overnight rates approached zero and central banks were unwilling to permit them to become negative, they turned to QE, mostly focusing on forcing down low-risk rates (out of a concern for distorting the allocation of capital across the economy) and allowing markets to bring down high-risk rates.

Consequently, QE tightens spreads over overnight interest rates and since spreads over blew out during the crisis, this is commonly seen as a positive outcome and even a sign that the overall problem is being resolved. However, such an interpretation misses the possibility, if not the fact, that broader spreads are rational market reactions to an underlying shift in the distribution of supply. In such a case, QE cannot help but distort otherwise efficient markets, no matter what assets are purchased.

Indeed, limiting purchases to low-risk assets may serve to further distort any “mismatch” between the distributions of supply and demand. Many intermediaries operate under strict, and slow moving, institutional mandates that limit their exposure to long-term, high-risk assets. Such market participants are simply unable, even in the medium term, to participate in the portfolio rebalancing that CBs seek. The efficacy of such a strategy may therefore decline as those agents that are able to participate become increasingly saturated in their purchases of high-risk debt (and in so doing are seen as risky themselves and so unable to raise funds from the constrained agents).

Furthermore, QE in the form of open market purchases of bonds, no matter whether they are public or private, automatically implies a bias towards large corporates and away from households and small businesses that rely exclusively on bank lending for credit. Bond purchases directly lower interest rates faced by large corporates (through portfolio rebalancing), but only indirectly stimulate small businesses or households via bank funding costs. In an environment with reduced competition in banking and perceived fragility in the financial industry as a whole, funding costs may not decline in response to QE and even if they do, the decline may not be passed on to borrowers.

In any event, a direct consequence of QE at the ZLB must be a reduction in the expected profitability of the financial industry as a whole and with it, a corresponding decline in the industry’s ability to withstand negative shocks. Given this trade-off, optimal policy at the ZLB should expressly consider financial system fragility in addition to inflation and the output gap, and when the probability of a negative shock rises, the weight given to such consideration must correspondingly increase.

How, then, to stimulate the real economy? Options to mitigate such a trade-off might include permitting negative nominal interest rates, at least for institutional investors; engaging in QE but simultaneously acting to improve financial industry resilience by, for example, mandating industry-wide constraints on dividends or bonuses; or, perhaps most importantly, acting to “correct” the risk distribution of long-term assets. The first of these is not without its risks, but falls squarely within the existing remit of most central banks. The second would require coordination between monetary and regulatory policy, a task eminently suited to the Bank of England’s new role. The third requires addressing the supply shock at its source and so its implementation would presumably be legislative and regulatory.

If further QE is deemed wise, it may also be necessary to grit one’s teeth and shift purchases out to (bundles of) riskier assets, if only maximise their effect. Given the distortions that already occur with low-risk purchases, this may not be as bad as it first seems.

Active monetary research can help inform all of these options, but more broadly, should perhaps focus not just on identifying the mechanisms of monetary transmission but also consider their resilience.

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Bitcoin

Update 11 September 2014: My views on digital currencies, including Bitcoin, have evolved somewhat since this post. Interested readers might care to read two new Bank of England articles on the topic. I was a co-author on both.

Original post is below …

Discussion of it is everywhere at the moment.

The Economist has a recent — and excellent — write-up on the idea.  My opinion, informed in no small part by Tyler Cowen’s views (here, here and here) is this:

  • Technically, it’s magnificent.  It overcomes some technical difficulties that used to be thought insurmountable.
  • As a medium of exchange, it’s an improvement over previous currencies (through the anonymity) for at least some transactions
  • As a store of value (i.e. as a store of wealth), it offers nothing [see below]
  • There are already many, many well-established assets that represent excellent stores of value, whatever your opinion on inflation and other artefacts of government policy
  • Therefore people will, at best, store their wealth in other assets and change them into bitcoins purely for the purpose of conducting transactions
  • As a result, the fundamental value of a bitcoin rests only in the superiority of its transactional system; for all other purposes, its value is zero
  • For 99.999% of all transactions by all people everywhere, the transaction anonymity is in no way superior to handing over physical cash or doing a recorded electronic transfer
  • Therefore, as a first approximation, bitcoin has a fundamental value of zero to almost everybody and of only slightly more than zero to some people

This thing is only ever going to be interesting or useful to drug dealers and crypto-fetishists.  Of those, I believe that drug dealers will ultimately lose interest because of a lack of liquidity in getting their “money” out of bitcoins and into hard cash.  That only leaves one group …

A note on money as a store-of-value:  When an asset pays out nothing as a flow profit (e.g. cash, gold, bitcoin), then that asset’s value as a store-of-value [1][2] is ultimately based on a) the surety that it’ll still exist in the future and b) your ability to convert it in the future to stuff you want to consume.  Requirement a) means that bread is a terrible store of value — it’ll all rot in a week.  Requirement b) means that a good store of value must be expected to have strong liquidity in the future.  In other words, there must be expected future demand for the stuff.  If you think your government’s policies are going to create inflation, putting your wealth in, say, iron ore, will be an excellent store of value because the economy at large will (pretty much) always generate demand for the stuff.

That makes gold an interesting case.  Since there isn’t really that much real economic demand for gold, using it as a store of value in period T must be based on a belief that people in period T+1 will believe that it will be a good store of value then.  But since we already know that it has very little intrinsic value to the economy, that implies that the T+1 people will have to believe that people in period T+2 will consider it a store of value, too.  The whole thing becomes an infinite recursion, with the value of gold as a store-of-value being based on a collective belief that it will continue to be a good store-of-value forever.

Bitcoin faces the same problem as gold.  For it to be a decent store-of-value, it will require that everybody believe that it will continue to be a decent store-of-value, and that everybody believe that everybody else believes it, and so on.  The world already has gold for that purpose (and gold has at least some real-economy demand to keep the expectation chain anchored).  I’m not at all sure that we can sustain two such assets.

[1] All currencies are assets.  They’re just don’t pay a return.  Then again, neither does gold.

[2] Yes, yes.  Saying that it’s “value as a store-of-value” is cumbersome.  It’s a definitional confusion analogous to free (as in beer) versus free (as in speech).

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Defending the EMH

Tim Harford has gone in to bat for the Efficient Market Hypothesis (EMH).  As Tim says, somebody has to.

Sort-of-officially, there are three versions of the EMH:

  • The strong version says that the market-determined price is always “correct”, fully reflecting all public and private information available to everybody, everywhere.
  • The semi-strong version says that the price incorporates all public information, past and present, but that inside information or innovative analysis may produce a valuation that differs from that price.
  • The weak version says that the price incorporates, at the least, all public information revealed in the past, so that looking at past information cannot allow you to predict the future price.

I would add a fourth version:

  • A very-weak version, saying that even if the future path of prices is somewhat predictable from past and present public information, you can’t beat the market on average without some sort of private advantage such as inside information or sufficient size as to allow market-moving trades.

    For example, you might be able to see that there’s a bubble and reasonably predict that prices will fall, but that doesn’t create an opportunity for market-beating profits on average, because you cannot know how long it will be before the bubble bursts and, to regurgitate John M. Keynes, the market can remain irrational longer than you can remain solvent.

I think that almost every economist and financial analyst under the sun would agree that the strong version is not true, or very rarely true.  There’s some evidence for the semi-strong or weak versions in some markets, at least most of the time, although behavioural finance has pretty clearly shown how they can fail.  The very-weak version, I contend, is probably close to always true for any sufficiently liquid market.

But looking for concrete evidence one way or another, while crucially important, is not the end of it.  There are, more broadly, the questions of (a) how closely each version of the EMH approximates reality; and (b) how costly a deviation of reality from the EMH would be for somebody using the EMH as their guide.

The answer to (a) is that the deviation of reality from the EMH can be economically significant over short time frames (up to days) for the weak forms of the EMH and over extremely long time frames (up to years) for the strong versions.

The answer to (b), however, depends on who is doing the asking and which version of the EMH is relevant for them.  For retail investors (i.e. you and me, for whom the appropriate form is the very-weak version) and indeed, for most businesses, the answer to (b) is “not really much at all”.  This is why Tim Harford finishes his piece with this:

I remain convinced that the efficient markets hypothesis should be a lodestar for ordinary investors. It suggests the following strategy: choose a range of shares or low-cost index trackers and invest in them gradually without trying to be too clever.

For regulators of the Too-Big-To-Fail financial players, of course, the answer to (b) is “the cost increases exponentially with the deviation”.

The failure of regulators, therefore, was a combination of treating the answer to (a) for the weak versions as applying to the strong versions as well; and of acting as though the answer to (b) was the same for everybody.  Tim quotes Matthew Bishop — co-author with Michael Green of “The Road from Ruin” and New York Bureau Chief of The Economist — as arguing that this failure helped fuel the financial crisis for three reasons:

First, it seduced Alan Greenspan into believing either that bubbles never happened, or that if they did there was no hope that the Federal Reserve could spot them and intervene. Second, the EMH motivated “mark-to-market” accounting rules, which put banks in an impossible situation when prices for their assets evaporated. Third, the EMH encouraged the view that executives could not manipulate the share prices of their companies, so it was perfectly reasonable to use stock options for executive pay.

I agree with all of those, but remain wary about stepping away from mark-to-market.

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The ECB starts raising interest rates (updated)

[Updated to include labour cost inflation too]

Here are the stories at the FT, the WSJ, the Economist (in their blogs) and for a won’t-somebody-think-of-the-children perspective, the Guardian [1].

There are plenty of arguments against the increase.  You could argue that there’s a sizeable output gap, so any inflation now is unlikely to be persistent.  You could argue that core inflation is low and that it’s only the headline rate that’s high.  You could argue that with the periphery countries facing fiscal crises, they need desperately to grow in order to avoid a default or, worse, a breakup of the Euro area.  You could argue that a period of above-average inflation in Europe’s core economies and below-average inflation in the periphery would allow the latter to (slowly) achieve what a currency devaluation would normally do:  make them more competitive, attract business and allow them to grow in the long run (above and beyond the short-run stimulus of low interest rates).

On that last point, though, it’s worth looking at the data.  It’s a great idea, in principle, but unfortunately and despite all the austerity packages, the data show exactly the opposite picture at present.  Here’s the current year-over-year inflation rate broken down by country, from Eurostat (HICP and Labour Costs):

 

 

Economy HICP Labour Cost Index
Euro area as a whole 2.4% 2.0%
Germany 2.2% 0.1%
France 1.8% 1.5%
Greece 4.2% 11.7%
Ireland 0.9% n/a
Portugal 3.5% 1.0%
Spain 3.4% 4.1%

 

 

For some reason Ireland doesn’t seem to be included in the Labour Cost data.  Look at Greece and Spain.  They’re getting more expensive to do business in relative to Germany and France.  Portugal is in the right area, but with Germany’s growth rate in Labour Costs so low, they’re still coming out worse.  The same story is painted in consumer inflation.  It looks like Ireland is doing what it needs to, but Greece, Portugal and Spain are all getting even less competitive.

Here’s my theory:  The ECB hates the fact that they’re temporarily funding these governments, but can’t avoid that fact.  Furthermore, they reckon that Greece, Ireland and Portugal are eventually going to restructure their debt.  Given that they cannot shove the temporary funding off onto some other European institution, the ECB either doesn’t care whether it’s in 2013 or today (they’ve already got the emergency liquidity out there and it can just stay there until the mess is cleaned up) or quietly wants them to do it now and get it over with.  Either way, the ECB is going to conduct policy conditional on the assumption that it’s as good as done.

 

[1]  Just kidding, Guardian readers.  You know I love you.  Mind you, the writing in that article could have been better — it says that inflation has gone above the ECB’s target of 2% and never mentions what it actually is, but later mentions the current British inflation rate (4.4%) without explaining that it is for Britain and not the Euro area.

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Some brief thoughts on QE2

  • Instead of speaking about “the interest rate” or even “the yield curve”, I wish people would speak more frequently about the yield surface:  put duration on the x-axis, per-period default risk on the y-axis and the yield on the z-axis.  Banks do not just borrow short and lend long; they also borrow safe and lend risky.
  • Liquidity is not uniform over the duration-instantaneous-default-risk space.   Liquidity is not even monotonic over the duration-instantaneous-default-risk space.
  • There is still a trade-off for the Fed in wanting lower interest rates for long-duration, medium-to-high-risk borrowers to spur the economy and wanting a steep yield surface to help banks with weak balance sheets improve their standing.
  • By keeping IOR above the overnight rate, the Fed is sterilising their own QE (the newly-injected cash will stay parked in reserve accounts) and the sole remaining effect, as pointed out by Brad DeLong, is through a “correction” for any premiums demanded for duration risk.
  • Nevertheless, packaging the new QE as a collection of monthly purchases grants the Fed future policy flexibility, as they can always declare that it will be cut off after only X months or will be extended to Y months.
  • It seems fairly clear to me that the announcement was by-and-large expected and so “priced in” (e.g. James Hamilton), but there was still something of a surprise (it was somewhat greater easing than was expected) (e.g. Scott Sumner).
  • Menzie Chinn thinks there is a bit of a puzzle in that while bond markets had almost entirely priced it in, fx-rate markets (particularly USD-EUR) seemed to move a lot.  I’m not entirely sure that I buy his argument, as I’m not entirely sure why we should expect the size of the response to a monetary surprise to be the same in each market.
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Gold vs. US Treasuries

John Hempton writes:

We live in a strange world – the 10 year US Treasury is trading with a 2.63 percent yield.  The market is presuming that there will not be much inflation in those ten years.  However if there is deflation (as per Japan) then the 10 year will wind up being a very good investment (see my blog post on Japanese bond yields from the perspective of a Japanese household).

At the same time gold is appreciating very sharply – from $950 per oz to $1250 in the past year – and from $800 two years ago or $450 five years ago.  On the face of it the gold price is predicting inflation.

Try as I may – I can’t see any reason why both those prices are correct.  I have long held the view that prices are mostly sort-of-rational … [s]o either there is a theoretical way in which both these prices can be correct or even my weak version of the efficient market hypothesis is spectacularly wrong.

and then asks

My first question thus is can anyone tell me why these prices could possibly be consistent?  Is there a rational reason why the bond market is pricing low inflation and the gold market seemingly pricing high inflation?  Does anybody have the ingenious world view in which both these prices are correct?

Since Blogger rejected my comment over at John’s site as being too long, I may as well reproduce it here. I don’t know about “correct” and I’m no finance guy, so my first point is that  I have no freakin’ clue.  Nevertheless, here are five, somewhat contradictory ideas, three of which might fit in a weak EMH world …

Idea #1) Yes, yes, your whole post was predicated on some weak version of the EMH. However … Treasuries, despite what the arch-conservatives are saying, are unlikely to be in a bubble (see idea #4 below).  It might (and only might!) even be impossible for them to be in a bubble.  On the other hand, gold can experience a bubble (to the extent that you concede that bubbles can exist at all).  Just because it can doesn’t mean that it currently is in one, but if it is and treasuries are not, that would partially resolve your dilemma.

Idea #2) Gold, as a commodity, is a affected by global phenomena, whereas US treasuries, while obviously still influenced by global pressures, are more sensitive to the US economy than is gold.  This statement will become more true over time as the US economy shrinks as a share of global GDP.  Therefore, perhaps you should deduce that markets are predicting low inflation or deflation for America, but quite high inflation for the world as a whole.

Idea #3) Gold, as a commodity, partially co-moves with other commodities, many of which are seeing price increases because of real, observable events in their markets (Chinese construction, Russian drought, etc).  Perhaps it is being dragged up by those (this augments idea #2).

Idea #4) In the broad market for USD-denominated investment-grade bonds, there has, I believe, been a net contraction in supply despite the surge in US government borrowing.  This is the private-sector balance-sheet correction.  One might argue, from something of a monetarist point of view, that (disin|de)flation is occurring in the US precisely because the US government is not expanding its borrowing fast enough to replace the private-sector contraction.  I mentioned this briefly the other day.

Idea #5) Another non-EMH idea, I’m afraid:  Both the USD and gold enjoy safe-haven status.  An increase in generalised fear (Knightian uncertainty, unknown unknowns, etc) will shift out the demand for both at all price levels.  To the extent that such a dynamic exists, I suspect that it ebbs away only slowly and, while elevated, is susceptible to rapid increases in response to events that would, in normal times, not affect people so much.

Update 11 Oct 2010:

James Hamilton on essentially the same topic.

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Improving the Euro

On BBC Radio 4, Jonathan Charles — the BBC’s European correspondent in the 1990s — has done a special on the Euro and the trouble it’s experiencing.  It’s well worth a listen if you have 40 minutes to spare.

It reminded me that I’d meant to write a post on two things I think ought to be done in improving the long-term outlook for the single currency.  None of this is particularly innovative, but I needed to put it down somewhere, so here it is.

First, a European Fiscal Institution (EFI)

At the start of February, when Greece and her public debt was dominating the news, I wrote:

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.

Let me hang some meat on those not-even-bones.  I like the idea of a partially shared, European Fiscal Institution (EFI) that can conduct counter-cyclical spending, subject to strict limits on its mandate.  I am deliberately avoiding calling it an “authority” because that implies a certain freedom of action, which I oppose.  Instead, I think that an EFI should:

  • be limited to implementing commonly-agreed automatic stabilisers (in particular, a universally-agreed-upon minimum level of unemployment benefits);
  • be able to issue its own “Euro bonds”;
  • have a mandate to retain the very highest regard for the safety of its borrowing; and
  • be funded (and its bonds be guaranteed) by member countries in a manner part way between proportionate to population and proportionate to GDP.

I do not think that membership of such an institution should be required of any European country.  If a non-Euro country wants to be in it, fine.  If a Euro country wants to not be in it, fine.

The unemployment benefits provided would be the absolute minimum that everyone could agree on.  I want to emphasise that this should be extremely conservative.  If it ends up being just €100/week for the first month of unemployment, so be it; so long as it is something.  Member countries would provide additional support above the minimum as they see fit.

This will have several benefits:

  • It will help provide pan-European automatic stabilisation in fiscal policy.
  • It will provide crucial intra-European stabilisation.
  • It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high.
  • It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

Second, country-specific lending standards

A crucial problem with a single currency is that it imposes a one-size-fits-all monetary policy on all member states, even when those states’ economies are not perfectly synchronised.  Synchronisation was, and is, one of the requirements for accession to the Euro, but perfect synchronisation is impossible.  In particular, inflation rates have varied significantly across the Euro-area, meaning that the common-to-all interest rates set by the ECB have been, by necessity, too low for those economies with the highest rates of inflation (e.g. Spain) and too high for those with the lowest rates of inflation (e.g. Germany).

But the (causal) link from interest rates to inflation travels via the extension of credit to the private sector, and the level of credit is determined not just from the demand side (with agents responding to changes in interest rates), but also from the supply side (with banks deciding to whom and under what conditions they will grant credit).  Monetary authorities in individual member countries therefore retain the ability to influence the level of credit through regulatory influence on the supply of the same.

Altering reserve requirements for banks operating in one’s country would be the crudest version of this mechanism. A more modern equivalent would be changes to the minimum level for banks’ capital adequacy ratios.  Imagine if the Spanish banking regulators had imposed a requirement of 10% deposits on all mortgages from 2005.

I suspect that the new “macro-prudential” role of the Bank of England, in addition to its role of more conventional — and, with Q.E., unconventional — monetary policy will grant them the ability to engage this sort of control.  I think it will become more important over time, too, as the British economy continues its (to my mind inevitable) decline relative to the Euro-area, the UK moves closer to the textbook definition of a “small, open economy” and the BoE thus finds itself more constricted in their choice of interest rates.

Update 13 September 2010:

The new Basel III capital adequacy requirements are out and they appear to enable exactly this second idea.  Good!