Monday, April 16, 2012

I don't understand what Mohammad El-Erian is saying here.

I do entirely sympathise with this

a professor ...advised me that, in order to maximize the probability of success, I should ... Make sure to cover issues where I know more than those who will be evaluating my work; and, in putting everything together, make sure that I mix and match among components that no one in their right mind would ever combine!
I did not listen to this professor’s advice back in 1980, and I have not done so today. Indeed, I have gone the other way! And in so doing, I suspect that I will get very close to – and perhaps even cross, though I hope not – that delicate line that every speaker faces and fears: the one that separates courage from stupidity.

He is not a central banker.  I know almost nothing about real world finance.  This post will definitely demonstrate my ignorance, but it might be interesting anyway.

update: My worse concern is that, while typing, I had the vague sense that Krugman had written something very vaguley similary to what I was typing.  I fear I am passing off Krugman's arguments (which I don't remember) as my own.  More than that, I fear I am a victim of Krugmanic possession and that I have lost my ability to think independely of him.

El-Erian's main argument is that central banks can't and shouldn't bear the full burden of stimulating the economy, that is (I assume) there should be fiscal stimulus too.  I absolutely agree with that (although he doesn't exactly explain what he means).  But his discussion of disadvantages of central bank interventions is very odd to me.

He seems to define the normal situation and the free market outcome to be the way things were before 2007.  But the system was headed for catastrophe then.  It was distorted by the irrational confidence some had in the boundless wealth of investment banks and, for the less naive, by to big to fail moral hazard.

There are also genuine concerns that such activism involves a range of collateral damage and unintended consequences, only some of which are visible at this stage. And there will be questioning whether all this continues to be justified by central banks’ impact on the overall economy.
Already, there are visible changes to the characteristics and functioning of certain markets. As an example, consider what is happening to the money markets segment.
With policy interest rates floored at zero for such an extended period of time (past and also prospectively, according to recent FOMC statements), this segment will continue to shrink – and will do so mostly from the supply side. Funds are being re-intermediated to the banking sector, with quite a portion ending up in excess reserves at the Fed. In the process, borrowers that previously depended on money market investors (think here of commercial paper issuers as an example) are having to find alternative sources of funding. 

First he seems to be saying that low interest rates are bad for borrowers.  He doesn't quite say it, but what else does "having to find alternative sources of funding" mean ?  Why don't they just pay enough on commercial paper to make money market funds attractive ?  I'd say it is obvious that they are using alternative sources of funding, because those alternative sources are very attractive, because FOMC policy is very stimulative.

But my more general objection above is based on the fact that El-Erian seems to assume that the capitalisation of money market funds in say 2007 was appropriate, so a change is "collateral damage."  I have a rather different view of money market funds.  I consider them a fraud designed to evade necessary prudential regulation which, by itself, would have destroyed the US economy in the absense of public rescue.  They have been around for decades and worked fine until they collapsed entirely.  I think a reasonable level of their capitalisation would be zero -- they are entirely based on a promise not backed by anything (like deposits before the FDIC) which works fine until there is a panic.  They were saved by a legal only in a crisis rescue.  How can their decline be "collateral damage."

The idea always was that there are shares which are legally equity but which always happen to be equal one dollar.  Shareholders were not all aware that they owned shares not deposits and that there was no guarantee that a share would be equal to one dollar.  Since the shares are legally equity of a special purpose entity, parent corporations did not have to count them as liabilities when calculating capital ratios.  Nor did they have to hold reserves to redeem the shares.  Also they never paid the FDIC for insurance, but, it turns out they had it for free when they needed it.

The key to the whole approach was that the parent company made a market in the shares (so long as it could with no reason for people to have such faith that it always could given the absence of any prudential requirement for capital, reserves or insurance).  It seems to me that generally if firm A sets up firm B then buys and sells shares of firm B to make them more attractive to other investors we call it market manipulation and call in the SEC.  Sure doesn's sound like arms length transactions at market prices to me.

I'm old enough to remember the silly regulation which money market funds got around.  Once upon a time there were tight restrictions on nominal interest on deposits (zero for checking accounts IIRC).  I remember when banks offered toaster ovens to people who opened accounts (since they couldn't pay a market clearing interest rate).  I never had such an account (I was under 18 at the time).  This was a silly nominal rigidity (which by the way makes any time series econometrics which pools data from the regulation q era and the post regulation q era nonsense).  But it is long gone.

If the purpose of the funds is to convince people they have an asset as safe as a bank deposit without having to bother with capital or reserves, then I think the right policy response is to ban the funds. If the purpose is to get deposit insurance without paying for it, then I think the right policy is to ban the funds.  The people who set them up made a promise which people believed and which they couldn't keep in a crisis.  A decline of that sector does not strike me as collateral damage.


The functioning of markets is also changing given the size and scope of central bank involvement. The result is artificial pricing, lower liquidity and a more cumbersome price discovery process.
Huh ? I don't even know what this means (at all).  I don't see the basis for the conviction that high trading volume (liquidity) is socially desirable.  I think this confuses the interest of expert traders (who benefit from a high volume of fools who are willing to buy what they want to sell and vice versa) with market efficiency. It seems to me that the less cumbersome price discovery process of the recent past was associated with high price volatility and gigantic misspricing of assets largely driven by the irrational trading of expert traders.

Also how does one reconcile these two claims

The essence here was captured well in a recent investor remark reported by Bloomberg: “Investors are numb and sedated…. by the money sloshing around the system.”

Put differently, a view has evolved that the “trading” segment of markets, whose focus is understandably short-term, is now dominating the “investment” segment.
So numb and sedated investors are focusing on the short term as is demonstrated by low liquidity (that is low trading volume).  I just don't see how both claims can be true.

Somehow he seems to consider there to be a natural interest rate defined in a way very different from Wicksell and that the current interest rates are lower.  So some interest rate is the free market rate and another one isn't.  This sounds vaguely Austrian to me.  It doesn't make any particular sense as far as I can tell.

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