Author: Hafiz Noor Shams

For more about me, please read this.

Categories
Economics

[2557] Did the LTRO fail?

So after the rumor of bailout, the official denial and later the external pressure, Spain has finally requested for a bail out from Europe. The bailout is expected to be utilized, in turn, to bail out Spanish banks. The money will come from either the EFSF or the ESM, whichever is politically expedient.

Even before the request, the Spanish government has already bailed out its fourth largest banks just recently.

I find the bailout in Spain as curious because it raises one question: whatever happened to the LTRO?

Aren’t the LTRO with money worth EUR1 trillion meant to bail out banks implicitly?

Did the LTRO fail to do what it was meant to do, which was to give European banks very cheap refinancing options over 3 years? Did Spanish banks not gain access to the LTRO? What did the Spanish banks do with the LTRO?

Categories
Economics

[2556] The tradeoff between internal and external consistency

A good theory has two characteristics: internal consistency and external consistency. An internally consistent theory is one that is parsimonious; it invokes no ad hoc or peculiar axioms. An externally consistent theory is one that fits the facts; it makes empirically refutable predictions that are not refuted. All scientists, including economists, strive for theories that are both internally and externally consistent. Yet, like all optimizing agents, scientists face tradeoffs. One theory may be more “beautiful,” while another may be easier to reconcile with observation.

The choice between alternative theories of the business cycle—in particular, between real business cycle theory and new Keynesian theory—is partly a choice between internal and external consistency. Real business cycle theory extends the Walrasian paradigm, the most widely understood and taught model in economics, and provides a unified explanation for economic growth and economic fluctuations. New Keynesian theory, in its attempt to mimic the world more accurately, relies on nominal rigidities that are observed but only little understood. Indeed, new Keynesians sometimes suggest that to understand the business cycle, it may be necessary to reject the axiom of rational, optimizing individuals, an act that for economists would be the ultimate abandonment of internal consistency. [Real Business Cycles: A New Keynesian Perspective. Gregory N. Mankiw. Journal of Economic Perspectives. Volume 3, Number 3. 1989.

Categories
Economics

[2555] What is the best banking system for high-skilled service industry?

During the launch of IMF Regional Outlook a few months ago, Anoop Singh, the IMF director for the Asia-Pacific Region mentioned how the financial system is not ready for high-skilled service industry.

As his argument goes, banks usually demand collateral before providing any loans to businesses (or, mostly, anybody for that matter). This is perfectly fine for capital-intensive businesses but it becomes an issue when it comes to labor-intensive businesses. With little capital, there is little to function as meaningful concrete collateral. There are other things that can replace collateral like personal guarantee but such guarantee has to be credible and eventually means the businessowner’s personal assets. You still require some concrete assets in the end.

But what if you are nobody but you have a great idea that is labor-intensive?

Here, labor-intensive means just you and your partners maybe sitting down writing codes or running some weird but amazing business that, in the extreme for illustrative purpose, is one of pure brainpower, negligible capital requirement and no muscle, manned by individuals of limited wealth.

There are venture capitalists and that is usually the solution to the problem. But imagine a widespread proliferation of such industry that it becomes the dominant industry in an economy. Venture capital setup will be woefully inadequate as a source of funding.

The virtue of a bank (commercial bank) is its capability to pool large capital through aggregation of savings and to redistribute it elsewhere pretty painlessly. Venture capitalists are decidedly not as good as a traditional commercial bank at pooling resources.

This leads to a question, what is the solution?

I am unclear about that.

The banking system is inadequate as Mr. Singh points out but I am unsure if banks should evolve to not require concrete collateral to accommodate for the so-called new service industry if ever we come to that fork. Identifying a problem, while helpful, is very different from formulating a solution.

And an evolved banking system designed to not require collateral sounds like recipe for a banking crisis. A large percentage of businesses fail and without collateral, the banking system of such evolved banks would quickly be brought down to their knees. And a banking crisis, in the modern economy, will quickly turn into a widespread, horrible, economic crisis.

What about the government?

The problem of business failures will still be relevant but at least it addresses the banking system concern by socializing losses. I doubt the taxpayers will be happy with that.

Categories
Economics

[2554] Is the real interest rate too high?

Those whom keep a close eye on monetary policy will realize that the real interest rate at the moment is positive. My data suggests it is above 1% mark right now given how the Overnight Policy Rate is at 3% and inflation is hovering around 2% with core inflation being slightly lower than headline inflation.

Despite an abstraction and not directly observed like the everyday nominal interest rate, it is the real interest rate that is crucial in determining decision between consumption and saving/investment in most cases. This is not to say the nominal interest rate is not an abstraction. It still is but real interest rate is not immediately understood or observed by laypersons as nominal interest rate.

The reason I am bringing up the issue about real interest rate is that I think there is a worry of a slowdown in the domestic economy, especially with European and Chinese economies showing signs of stress. And I am always not keen of shoring up the economy with fiscal policy in the traditional way as long as monetary policy can do the jobs well. I also think that monetary policy has done an excellent job in the past few years amid serious unprecedented crisis despite Keynesian’s liquidity trap theory, which appears to be irrelevant: as market monetarists have successfully argued, the fixation on interest rate is overrated in zero-interest rate situation. Market monetarists, the successor to the monetarism of the 1970s, of course, argue more about monetary policy but let us leave that aside for now because I know they would not like my fixation with interest rate here.

With more than 1% real interest rate, this creates the incentive to save more than to spend in the economy. Or to invest less. The bottom line is that it has a negative impact on economic growth.

One also has to remember that the OPR is the base rate. There are other rates based on the OPR and they are priced higher. This means the relevant real interest rate are higher than 1% for consumers and businesses.

Furthermore, in the free (or rather, maybe, just efficient?) market, I would assume the optimal real interest rate is 0%. This suggests that even under free market environment, the real interest rate is too high.

There are other considerations in the settings of the rate. One big consideration is the management of inflation. But with demand-pull inflation coming down and with downside risk as far as growth is concerned, I think there is room to make the real interest rate more accommodative to economic growth without scaring the hawks away.

Categories
Economics

[2553] The lesson of Europe for Southeast Asia

Indonesian President Susilo Bambang Yudhoyono warned of the danger of a common currency in an interview with the Wall Street Journal. It is a reminder that needs not a resounding. The horror of Europe is enough to make one thinks twice of a currency union. The talks of Greek exit can potential become the end of the European dream.

The European crisis is a challenge to me partly because I am supportive of a currency union for Southeast Asia. Sometimes in the past, I contended to be associated with the term Aseanist.

More importantly, I am supportive of a currency union because of my free trade tendency: a union boosts trade because it reduces trade barrier significantly.

To be fair to myself, I support a union across similar economies and not wholly across the diverse Southeast Asia economies from the financially sophisticated Singapore to the tiny backwater East Timor.

Really, the lesson of Europe is not that monetary union does not work. The lesson is that monetary union works best for similar economies: the economic cycles mostly coincide, the structures are about the same, the culture of societies in it are not so different, etc.

I think I have made the case for a currency union for Malaysia, Singapore and Brunei for a start. In fact, Singapore and Brunei are already on a currency board, which effectively means de facto currency union. Malaysia is the natural extension of the Brunei-Singapore union because of its proximity and the massive interlinking between the three economies.

Then, there is perhaps historical hangover on my part, given how the original Malaysian proposal was a 15-state federation, with both Brunei and Singapore in it. Indeed, prior to 1973, all three currencies were interchangeable freely. Even before that between 1953 and 1967, all three countries used the same currency.

One issue with the Malaysia-Singapore-Brunei currency union is that the Singaporean economy tends to be more volatile than Malaysia. Nevertheless, I think in many ways, the direction of both economies are more or less the same. In that sense, the challenge of a monetary authority is to be more flexible and responsive to a more dynamic economy.