Chapter 1: The Cruise Ship and Aggregate Supply and
Aggregate Demand
Use the space below to draw a cruise ship that represents the US economy.
Key Terms from cruise ship example:
1. Fiscal policy
2. Monetary policy
3. Recognition lag
4. Implementation lag
5. Effectiveness lag
6. NAIRU
7. Full employment
8. Open market operations
9. Potential growth rate of economy
10. Stagflation
11. The FOMC
12. Exogenous shocks
13. Overheating
14. The new economy
15. Speed limit of the economy
16. Traditional model
1
The Cruise Ship
Goals (the port)
1. Stable Prices
2. Full Employment (NAIRU)
3. Economic Growth (PGE)
NAIRU (Non Accelerating Inflation Rate of Unemployment) – the lowest the
unemployment rate can go without inflation accelerating. We really don’t know exactly
what this number is and it probably changes through time. Most economists would agree
that NAIRU is lower today than it was back in 1995 and before.1
PGE (The Potential Growth rate of the Economy) – The fastest real GDP can grow
without inflation accelerating. This growth rate is often referred to as the speed limit of
the economy or the sweet spot of economic growth. Similar to NAIRU, PGE is a concept
and we are not really sure what number to use and thus, we often talk about NAIRU and
PGE in ranges. For example, I believe PGE is 4% which means that if GDP grows faster
than that, then inflation will accelerate and the Fed will have to respond by cranking up
interest rates to fight the incipient inflation. When Governor Olson was at here at Penn
State in April of 2006, he stated that the board believes that the PGE is around 3.25 –
3.5%. Any growth above that would be inflationary with the implication of overheating.2
Speed Limits of New vs. Old Economy
Old (traditional) Economy – pre 1995, before the surge in productivity in the late 90’s
NAIRU – 5.5% - 6%
PGE – 2.5%
New Economy – post 1995, after the surge in productivity in the late 90’s
NAIRU – 4 – 4.5
PGE – 3.25 – 4%
As stated previously, we are not sure what NAIRU and PGE are since they are
unobservable, but almost all economists would agree that these “speed limits” have
changed since 1995.3
The surge in productivity occurred somewhere around 1995 – 1996 and Alan Greenspan was arguably the
first to see this change. As we shall see, increases in the rate of productivity growth are dis-inflationary and
thus, helps the Fed in terms of achieving their price stability objective.
2
Overheating is a common ‘economic’ term and is associated with demand outstripping supply.
3
Note importantly that it is the growth rate of productivity that has surged and has changed the speed limit.
If the rate of productivity growth returns to its pre-1995 levels, then the speed limits (NAIRU: PGE) would
return to their pre-1995 levels as well. Due to this and other reasons, productivity growth statistics are
closely watched by policy makers and the public alike.
1
2
Policy Lags
1. Recognition lag: The recognition lag is the time it takes policy makers to know
the current level of economic activity as well as where the economy is headed. We
would think it would be easy to know current economic conditions given the constant
stream of economic data available, but this is not necessarily the case since much of
this data is reflecting previous economic activity. For a case in point of the
recognition lag consider the following: At an FOMC meeting in October of 1990,
Chairman Alan Greenspan did not recognize the economy was in the midst of an
“official recession,” a recession that is commonly referred to as the gulf war
recession.4
Lags are so important for policy makers and we assume that the recognition lag is the
same for Fiscal policy makers (FP) as it is for Monetary policy makers (MP). That is,
we assume that the economists that work on the council of economic advisors to the
President and the economists that work for the Federal Reserve are equal in their
abilities to recognize where the economy is and where it is headed.
2. Implementation lag: The implementation lag represents the time lag between
recognizing a need for discretionary policy and the time it takes to implement the
policy. For Fiscal policy, this lag can be quite long since our elected officials have to
write up the policy and then talk about the details. As we all know, the political
process, say, for a recommended tax cut can become very tedious and take many
months of discussion in either the House of Representatives and/or Congress.
For Monetary policy the implementation lag is very short, as the FOMC directs the
federal funds desk to change the target for the federal funds rate by conducting open
market operations. According to a high ranking Federal Reserve official, open
market operations take about 15 seconds to perform!
3. Effectiveness Lag: The effectiveness lag refers to the time it takes for the
implemented policy to influence real economic activity. In term of the cruise ship
example, it represents the time it takes for the cruise ship to turn once the wheel is
turned (i.e., once the policy is implemented). For Fiscal policy, the effectiveness lag
is thought to be relatively short. For example, once a tax cut becomes effective,
households immediately have more disposable income and chance are good, they will
spend it and thus, economic activity will rise quite quickly.
4
The National Bureau of Economic Research (NBER) is the official recession dating body and they
typically identify recessions well after they are over. For example, the trough (end of) the 2001 recession
occurred in November 2001 but wasn’t announced by the NBER until July 17, 2003! Chairman Bernanke
used to be a member of this committee. For all the official recession dates, as well as more information
about the process, go to http://www.nber.org/cycles/cyclesmain.html.
3
For Monetary policy, the effectiveness lag is long and variable, with the typical range
of time being anywhere from 6 months to 2 years.5 Some economists believe that the
effectiveness lag for monetary policy can be even longer than two years.6 This lag in
monetary policy means that the Federal Reserve must be forward looking and thus,
the “Fed” spends a lot of its resources in building and analyzing economic forecasting
models.
Exercise: In the Space below, draw a road and a car and discuss lags in policy and
the varying power of policy.
Monetary Policy
1. The Fed conducts open market operations (OMO) to keep the FF rate close to the
target
2. Open Market Sales – used to raise rates to the federal funds target
3. Open Market Purchases – used to lower rates to the federal funds target
Fiscal Policy
1. Changes in Government Purchases (G)
2. Changes in Taxes
Exogenous Shocks – an exogenous shock is an influence on the economy that is either
determined by ‘something’ outside of the economic model and/or is totally unexpected.
Examples of exogenous shocks:
1. 9/11
2. Y2K (even though we saw it coming)
3. Oil shocks
4. Stock market crashes
5. Wars
6. Financial crises (Asian, Russian, Argentina, Brazil, etc.)
5
This range is associated with the following reference: Milton Friedman and Anna Jacobson Schwartz, A
Monetary History of the United States, 1867-1960. Princeton: Princeton University Press (for the National
Bureau of Economic Research), 1963. xxiv + 860 pp.
6
When I spoke with Frederic Mishkin during his visit to Penn State, he suggested that the lag between
changes in Federal Reserve policy and its impact on inflation is “at least two years.” This fact must be kept
in mind since there is a group of economists adamant about inflation targeting, and thus, to successfully
target inflation, you must be able to forecast inflation 2 plus years into the future, a difficult task indeed!
4
Whether or not policy makers react to exogenous shocks depends on the nature of the
shock and to what degree it may jeopardize the Fed’s ultimate objectives. Policy makers
will consider a variety of factors when determining: a) whether or not react and b) the
degree of reaction. 9/11 serves as an example of a very serious negative exogenous
shock, one in which the Federal Reserve and Federal Government alike reacted strongly
to by conducting major expansionary monetary policy and expansionary fiscal policy
respectively.7
Boiler Example: An Informational Variable Approach to Monetary Policy
The Fed uses an “informational variable approach” to monetary policy. Instead of
watching only a few variables, policymakers watch all of them and depending on the
current economic environment, assign certain weights (importance) to each. The
composition and value of these weights evolve through time and Greenspan’s legacy
is exactly in this area – how does one choose these weights and the value associated
with each? It’s all in Greenspan’s head (not in a textbook!).8
Use the space below to construct the boiler example (an informational approach to
monetary policy):
Intermediate Targets
In the space below, draw a diagram depicting what exactly an intermediate target is and
the discuss the characteristics of a “good” intermediate target and then explain some
candidates for a good intermediate target. Relate the intermediate target analysis to the
boiler example.
7
The federal reserve immediately (the first business day) lowered their target for the federal funds rate by
50 basis points and eventually lowered the federal funds target to 1%, a forty year low. The Federal
Government responded by passing a significant tax cut.
Alan Greenspan has a reputation of conducting policy by “the seat of his pants.” From the WSJ
11/18/2004: "When Greenspan's replacement, whoever he or she is, walks into that office and opens the
drawer for the secrets, he's going to find it's empty," says Alan Blinder, a former Fed governor. "The
secrets are in Greenspan's head."
8
5
Demonstrating the Cruise Example in an aggregate supply (AS) / aggregate demand
(AD) framework.
From your econ 004 class, you should recall having been exposed to the AS/AD model,
as the AS/AD model is often the ‘workhorse’ of principles of macroeconomics. Let’s
begin with the aggregate supply side of the economy.
The Aggregate Supply (AS) side of the macroeconomy
When you think of AS, you should be thinking of production! There is a lot to discuss
when thinking about any particular production process. First, we need to consider the
production function (PF). Think of the production function as a ‘black box,’ one that
takes inputs (land, labor, capital, technology) and turns it into output, output that is
typically used to increase the welfare of society. In fact, it is often stated that increases in
the growth rate of productivity is the key to increasing living standards.
Exercise: In the space below, draw a production function and discuss the
assumptions underlying any production function, what the shape implies, and the
factors that cause the production function to shift.
6
Deriving Supply from the Production Function: A Plastering Example from my
econ 004 class.
Define MPL and MRP.
Fill in the table below and figure out how many workers I should hire to maximize
profits.
L
0
Q
0
1
10
2
25
3
36
4
45
5
52
6
55
MPL
-
MRP
-
Marginal Profit
-
Total Profit
0
The current wage is $80 and the price of output (Q) = $10.
In the space that follows, draw:
1) The production function
2) A labor market diagram including labor demand and labor supply
3) Derive the supply curve
7
Exercise: A Change in productivity
Let’s return to our original conditions and allow a technological innovation to increase
the productivity of each worker by two (assume no change in wages or output prices).
Fill in the table below. What is my profit maximizing level of labor input now?
L
0
Q
MPL
-
MRP
-
Marginal Profit
-
Total Profit
0
1
2
3
4
5
6
8
The current wage is $80 and the price of output (Q) = $10.
Exercise: Show the influence of the higher productivity on:
1) Your production function diagram
2) Your labor market diagram
3) Your supply curve Diagram
Exercise: Higher Wages and its influence on supply
Fill in the table below and figure out how many workers I should hire to maximize
profits.
L
0
Q
0
1
10
2
25
3
36
4
45
5
52
6
55
MPL
-
MRP
-
Marginal Profit
-
Total Profit
0
The current wage is $100 and the price of output (Q) = $10.
Exercise: Show the influence of the higher wages on:
1) Your production function diagram
2) Your labor market diagram
3) Your supply curve Diagram
Comments: The supply curve can shift for many reasons, we just discussed two of the
‘biggies’ when in comes to shifting supply. For the increase in productivity example, we
see that the supply curve shifts to the right, all else constant. Another way to think about
the increase in productivity is that it lowers the costs of production. That is, if we hire the
same amount of labor and incur the exact same costs of production, we can produce more
output. This being the case, we can also state, and this must be the case, that we can
produce the same output at a lower cost! So we can make this general statement:
9
Anything that lowers the costs of production will shift the AS curve to the right, all else
constant.
Conversely, anything that raises the costs of production will shift the AS curve to the left.
Our example with wages rising should convince us that higher labor costs will result in
less people working and thus, a decrease in the level of output produced.
Changes in productivity and the wage costs are probably the most important variables
when analyzing aggregate supply. We have already discussed the new economy and the
fact that increases in the growth rate of productivity is the key to increasing living
standards. With regard to wages, it is typically stated that wage costs account for
approximately 70% of the cost of producing any good or service.9
Exercise: Determine which direction the AS curve shifts for each of the following
changes:
1. Wages rise.
2. Environmental regulation eases.
3. A rise in the corporate income tax.
4. Law that accelerates the amount that firms can write off in the form of depreciation
allowances.
5. A government subsidy for new investment.
6. Lower interest costs.
7. A rise in inflationary expectations.
8. The US dollar weakening that results in more expensive imported raw materials.
9. A decrease in raw material costs.
10. A rise in productivity growth.
11. A fall in the price of energy.
The New Economy and the movement of the Port
The surge in productivity that began during the beginning of 1996 has effectively
changed the speed limit of the economy and thus, changed the location of the port (see
diagram below).
9
This is a general statement. Naturally, the proportion of labor costs to total costs depends on the nature of
the production processes (i.e., labor intensive vs. capital intensive).
10
The Aggregate Demand (AD) Side of the Economy
First off, we need to realize that policy makers are aggregate demand (AD) side
managers. That is, discretionary Monetary and Fiscal policies are aimed at influencing
AD and not AS.10
Think of AD as being summarized by the following:
AD = C + I + G + (X-M)
Where:
C = Personal Consumption Expenditures (henceforth: Consumption)
I = Gross private domestic investment (henceforth: Investment)
G = Government Purchases
(X-M) = Net Exports (exports minus imports)
Consumption (Personal Consumption Expenditures)
Consumption is by far the biggest component of aggregate demand, accounting for
approximately two thirds of GDP. Before discussing in detail the determinants of
consumption, we begin with its elements.
During the President Reagan years (1980 – 1988), his administration arguably conducted some supply
side economics where policy was directed towards influencing the AS curve. Coined “Reaganomics,”
these policies were controversial with terms like “trickle down” and “voo doo” economics becoming
popular. Since this episode, however, most economists are back to thinking that policies generally work
through AD and not AS.
10
11
Elements of Consumption
1) Non-durable Goods – These are the goods that are tangible but are not meant to last
over three years. Items such as food, clothing, and textbooks fall into the non-durable
good element of consumption. According to 2006 data, non-durable good consumption
represented 29% of total consumption.
2) Durable Goods – These goods are meant to last three years or more. Items such as
home appliances, automobiles, furniture, and other “big ticket” items fall into the durable
good category of consumption. Durable goods statistics are closely monitored by
economists as a gauge of current and future economic activity. For example, economists
believe that a fall in durable goods purchases may signal a weaker economy ahead in the
following way: If consumers are uncertain and insecure about future income, one of the
first signals would be a drop off in durable goods consumption (big ticket items). That is,
consumers will hold off buying a new car, a new washer and dryer, etc. Also important,
the demand for durable goods are thought to be interest sensitive and this provides us
with a link between durable goods consumption and monetary policy (more on this
below). According to 2006 data, durable goods consumption represented 12% of total
consumption.
3) Services – Services account for the biggest proportion of consumption. According to
2006 data, the service element of consumption accounted for 59% of total consumption.
Services are non-tangible. You are consuming a service by taking this class since the
human capital enhancement is non-tangible. Going to a concert, a football game, getting
a haircut, etc. are all services.
The figure below depicts consumption as a percentage of GDP since 1980.11
11
Source: The Federal Reserve Economic Database (FRED): Federal Reserve Bank of St. Louis. The data
are quarterly (1980:1 – 2002:3).
12
Consumption as a Percentag e of GDP
72
70
68
66
64
62
60
80
82
84
86
88
90
92
94
96
98
00
02
Observations:


Most recently, consumption accounts for approximately 70% of GDP! It is no
surprise that consumption and the determination of consumption receives so much
attention in economic research. We will discuss the determinants of consumption
shortly.
Since 1998, consumption, as a percentage of GDP has increased. Can you explain
why?
Investment (Gross Private Domestic Investment)
Investment is a very important component of aggregate demand. We have already
learned about the new economy and that the source of the new economy was a surge in
the growth rate of (worker) productivity. Naturally, investment in technology is a big
factor underlying the surge in worker productivity. Also of note, many economists
believe that investment expenditures are quite sensitive to interest rates (the cost of
borrowing), thus giving us a direct link between monetary policy and investment
expenditures.
Elements of Investment
1) Residential Structures – Simply put, new homes. The housing market has been quite
strong with significant rates of appreciation in many if not most areas.12 One reason the
housing market has been performing so well is due to very low mortgage rates. The
figure below depicts the drop in mortgage rates once the US economy began to slow
(2000).
As of this writing (06/06/06), the housing market has been the Fed’s radar screen as some fear that a
housing bubble exists, that is, real estates prices in many areas are “too high.”
12
13
2) Non Residential Structures – These include all structures that are non-residential,
often referred to as commercial real estate. Naturally, the non-residential structures
element of investment is thought to be interest rate sensitive (as was the case with
residential structures).
3) Tools, Equipment, and Software – This element of investment has been the weakest
sector in the economy. This element is very important since it plays such a critical role in
determining worker productivity. The figure below shows how weak this sector has been
of late.13
13
Source: The Federal Reserve Board: Monetary Policy Report to the Congress, February 11, 2003.
14
4) Inventories – This element of investment is also closely watched by economists. For
example, an increase in inventories can be intentional or unintentional. If the increase in
inventories is intentional, then firms expect stronger demand in the future and in order to
satisfy the increased demand, they will build up inventories (increasing employment).
Conversely, if the increase in inventories is unintentional, then firms incur excess
inventories and will cut back on production and thus lay off workers. See if you can use
the same logic in terms of explaining the good [/] bad signals that lower inventories may
send. Below is a picture depicting the recent behavior of inventories.14
14
Source: The Federal Reserve Board: Monetary Policy Report to the Congress, February 11, 2003.
15
Observation:
 Inventories were growing well up until the economy slowed (the recession,
according to the National Bureau of Economic Research (NBER) officially began
in March of 2001 and ended in November of 2001). Most probably, firms did not
forecast such a slowdown and thus had excess inventories. From the figure, you
can see the “working off” of the excess inventories during 2001 and the first half
of 2002.
The figure below depicts investment as a percentage of GDP since 1980.15
Investment as a Percentag e of GDP
19
18
17
16
15
14
13
80
82
84
86
88
90
92
94
96
98
00
02
15
Source: The Federal Reserve Economic Database (FRED): Federal Reserve Bank of St. Louis. The data
are quarterly (1980:1 – 2002:3).
16
Observations:


Investment is cyclical. That is, investment as a percentage of GDP is related to
the stage of the business cycle. For example, investment falls as a percentage of
GDP when the economy is in recession. Recall the dates of recent US recessions
(1980 – 1982, 1990-1991, and the most recent recession beginning in March of
2001).
Investment as a percentage of GDP rises when the economy is growing strong. In
particular, note the increase in investment as a percentage of GDP during the new
economy years (1996-2000).
Government Purchases – By Government Purchases we mean just that, purchases and
not spending. For example, transfer payments such as social security expenditures,
welfare payments, and unemployment insurance are not included in government
purchases.
The figure below depicts government purchases as a percentage of GDP since 1980.16
Government Purchases as a Percentag e of GDP
22
21
20
19
18
17
80
82
84
86
88
90
92
94
96
98
00
02
Observations:

Government purchases as a percentage of GDP has fallen since the early 1990s.
This fact, along with very strong rates of economic growth during the latter half
of the 1990s helps us understand the movement from federal budget deficits to
federal budget surpluses during this time.
16
Source: The Federal Reserve Economic Database (FRED): Federal Reserve Bank of St. Louis. The data
are quarterly (1980:1 – 2002:3).
17

Most recently, government purchases are rising as a percentage of GDP, perhaps
reflecting the expansionary fiscal policy conducted by fiscal authorities in
reaction to the US recession that began in March of 2001.
Net Exports – Net exports are simply defined as the value of exports (from US) minus
the value of imports (to the US). Net exports have been negative for some time now
implying that the value of imports exceeds the value of exports – i.e., we have a trade
deficit. We will discuss why this is so below.
Net Exports as a Percent of GDP
1
0
-1
-2
-3
-4
-5
80
82
84
86
88
90
92
94
96
98
00
02
Observation:
 Throughout the 1990s, net exports have become more of a negative in terms of its
percentage of GDP. Two determinants of this phenomenon are worthy of noting:
1) The US economy was growing faster than the economies of our trading
partners during this time (especially Japan). In simple terms, this difference in
economic growth rates implies that our (the US) appetite for purchasing foreign
goods exceeds the foreign economies’ appetite for purchasing US goods. Result:
imports exceed exports leading to a larger trade deficit. 2) Since the US economy
was performing so well, investors invested in US stocks and bonds. This influx of
capital flows strengthened the value of the US dollar, relative to the currencies of
our trading partners. The stronger US dollar results in cheaper US imports and
raises the price of US exports, again, implying a larger trade deficit.
Constructing a realistic consumption function
Since consumption is such a big component of AD, we will focus most of our attention
towards consumption. The primary determinant of consumption is disposable income.
We have also mentioned that the level of interest rates play a role in determining the level
of consumption expenditures.
18
Formal Model of consumption (determinants)
+ +
+
+
C = f { Yd , r, WSM, WRE, CC}
Stated as Consumption is a function of:
1) Yd = disposable income; The relationship is positive and the sensitivity of
consumption to changes in Yd is referred to as the marginal propensity to consume.
2) r = the real interest rate: Consumption is inversely related to changes in the real rate of
interest (more on this below).
3) WSM = wealth in the stock market: Consumption is positively related to changes in
WSM.
4) WRE = wealth in real estate: Consumption is positively related to changes in WRE.
5) CC = consumer confidence and consumption is positively related to changes in
consumer confidence.
Policy Implications
Monetary policy can directly influence the level on consumption expenditures through
changes in the real rate of interest. The lower the real rate of interest, the more people
will consume, all else constant.
Fiscal Policy can directly influence consumption primarily through tax policy. Lower
tax rates, for example, will increase disposable income thus increasing consumption with
the influence being sensitive to the size of the tax cut and the value of the marginal
propensity to consume.
Fiscal Policy also influences consumption indirectly through what is referred to as the
Keynesian multiplier. For example, if G rises, that will create jobs and when the people
who began working spend their money, that will in turn, create more jobs and thus, result
in more consumption.
A Forecasting Equation – In order to get a handle on consumption, we can set up a
forecasting equation
C = a0 + a1 (Yd) + a2 (r) + a3 (WSM) + a4 (WRE) + a5 (CC)
Where the ai ‘s are sensitivity parameters. Draw a consumption function below and
discuss all the shift variables.
19
Investment – The investment component of AD is probably the most interest rate
sensitive of all the components of aggregate demand. In the space below, draw an
investment demand function and discuss shifts in the investment demand function.
Government Purchases - Changes in government purchases influence AD directly and
indirectly through the ‘Keynesian multiplier.’ Discuss example from West Texas.
Net Exports – Even though this component of aggregate demand is getting larger as a
percent of GDP, we don’t rely on policy induced changes. Monetary policy has does
have an influence on net exports in the following way: In order to lower interest rates,
the Fed increases the money supply via open market purchases. Since US dollars are less
‘dear’ as a result, the value of the US dollar should weaken, relative to our trading
partners, all else constant. The weaker US dollar should deter imports since all else
constant, imports become more expensive with a weaker dollar. The substitution towards
domestic goods and away from the relatively more expensive imports will result in higher
AD since net exports will rise under these assumptions.17
AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
AD – policy variables ( r, T, G) and non-policy variables ( CC, IC, WSM, WRE, Ex)
AS – productivity, wages, other input costs
GDP = C + I + G + (X-M)
Key: AD = Aggregate Demand; AS = Aggregate Supply; r = real interest rate; T = taxes;
G = Government Purchases; CC = Consumer Confidence; IC = Investor Confidence and
can be used interchangeably with animal spirits; WSM = Wealth in the Stock Market;
WRE = Wealth in Real Estate, Ex = Exchange rate value of the US dollar; Ex rising
implies dollar appreciation; W = wages.
Positive and Negative Relationships
Positive – if the value of that variable increases, then AD/AS will increase
Negative – if the value of that variable increases, then AD/AS will decrease
17
Exchange rate determination is very complicated and quite frankly, the hardest of all the markets (Stocks,
Bonds, and Foreign Exchange) to figure out. So the exchange rate channel of monetary policy, as
discussed above, is built into the Fed’s model of the economy, but this influence is just one of many and
thus, is not relied upon.
20
Aggregate Demand
Positive: G, CC, IC, WSM, WRE (change in WRE has more influence then change
in WSM)
Negative: r, T, Ex (consider Ex to be increasing when the dollar appreciates)
Aggregate Supply
Positive: Productivity
Negative: W, BT, HB, Environmental policy, other costs of production
W = Wages; BT = Business taxes: HB = Health Benefits.
CLASSICAL vs. KEYNESIAN ECONOMICS
Pre-Great Depression
Classical: Government takes a back seat to natural (and unavoidable) fluctuations in
supply demand relationship. According to Classical Economists, policymakers
should be totally passive and allow markets to work.
Invisible Hand: If everyone pursues their own self interest, social welfare will be
maximized (works best with minimal government intervention) The invisible hand
theorem is associated with Adam Smith who is often referred to as the father of
economics
Show the Classical model in an AS/AD framework below being sure to emphasize
the self correcting mechanism
21
Depict the Great Depression in the space below
Keynesian: Keynes argued that wages and prices could be “sticky,” especially in the downward direction.
He promoted government intervention in the form of discretionary Fiscal Policy. Why not monetary
policy?
Showed the Keynesian model in an AS/AD framework (with “sticky” prices)
Article: Two majors points to emphasize: 1) Prescott and Kydland won noble prize for hands off policy
prescription; and 2) their work on real Business cycle analysis is contentious.
22
October 12, 2004
American, Norwegian Win Nobel
Prescott, Kydland Honored
In Economics for Research
Crucial to Central Banking
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL
October 12, 2004; Page A2
An American and a Norwegian were awarded the Nobel prize in economics for research
that laid the intellectual foundation for modern central banking and for their somewhat
controversial work that redefined how some economists think about the causes of
economic booms and busts.
The award went to Edward C. Prescott, 63 years old, an economics professor at Arizona
State University and longtime researcher with the Federal Reserve Bank of Minneapolis,
and his frequent collaborator Finn E. Kydland, 60, a Norwegian-born economist now on
faculty at Carnegie Mellon University in Pittsburgh and at the University of California at
Santa Barbara. Mr. Prescott has long been seen as a favorite to win the award; Mr.
Kydland has received less attention.
The Royal Swedish Academy of Sciences said the men's work has "profoundly
influenced the practice of economic policy in general and monetary policy in particular."
The reforms that central banks around the world undertook in part as a result of their
work "are an important factor underlying the recent period of low and stable inflation."
The main insight came in a paper called "Rules Rather than Discretion: The
Inconsistency of Optimal Plans," written in 1977. In that paper, the authors examined
how government policy makers invited long-term trouble when they strayed from their
goals to address short-run problems. They applied the theory to everything from patent
enforcement to federal disaster assistance, but it was in the area of central banking that
the ideas in the paper struck a chord. At the time, inflation was running rampant and
economic growth was stagnant -- a phenomenon called "stagflation."
23
Most central bankers around the world typically espoused a
commitment to contain inflation, but in practice central bankers
would shift policy to tolerate a little more inflation in the short run
as a trade-off for stronger economic growth and rising employment.
The professors showed how these short-term shifts in policy had
long-term consequences and could push up inflation expectations of
households and businesses, leading to long-running bouts of rising
prices.
"Kydland and Prescott's analysis provided an explanation for the
failure to combat inflation in the 1970s," the academy said. The key
to any policy, they argued, was to make a commitment and stick to
it. Central bankers responded by demanding more independence, so
that they would be less prone to interference by elected officials who were concerned
about short-term fluctuations in the economy. It also led many central banks -- such as
those of New Zealand, Sweden and the U.K. -- to adopt formal inflation targets to
underline the commitment to low inflation. "You should not think in terms of controlling
the
economy," Mr. Prescott says. "That leads to bad outcomes. You should
think in terms of committing to good policy rules."
Their research into business cycles has been more contentious. Before
the authors took up the subject in a 1982 paper, many economists
believed that economic booms and busts were caused by changes in
demand by consumers and businesses, a point espoused by John
Maynard Keynes, whose views dominated economic thought after the
Great Depression. Mr. Keynes prescribed government stimulus when
consumer spending or business investment softened.
But Messrs. Prescott and Kydland, who were the forefront of a broad
shift away from the teachings of Keynes, argued that other factors, most
notably a nation's productivity, were critical driving forces in short-term shifts in the
business cycle. They theorized that supply-side shocks, such as a new technological
innovation or a surge in the price of oil, could alter productivity patterns and cause a
recession or an economic boom. Before their work, economists thought productivity of a
nation's work force mainly affected long-term economic performance.
Those views about the business cycle may seem straightforward, but they remain
contentious even today, in part because they undercut arguments for the government to
act to stimulate demand when the economy weakens. Lawrence Summers, the president
of Harvard and the former U.S. Treasury secretary, once wrote that the work of Messrs.
Prescott and Kydland on business cycles had "nothing to do with the business-cycle
phenomena observed in the United States or other capitalist economies." In an e-mail
yesterday, Mr. Summers said the two professors "richly deserve" the prize because of the
economic methods they introduced, even though "I like many others find their particular
theories [about business cycles] implausible."
24
Messrs. Prescott and Kydland will share an award of 10 million Swedish kronor, or $1.4
million. The award is officially called the Bank of Sweden Prize in Economic Sciences in
Memory of Alfred Nobel. It is the last of six prizes announced by the Royal Swedish
Academy of Sciences; the others were all announced last week.
Write to Jon E. Hilsenrath at jon.hilsenrath@wsj.com3
Applications to the Aggregate Supply / Aggregate Demand Model
1. In the space below – Draw an aggregate supply / aggregate demand diagram and label the initial
equilibrium point as point A (assume this point is also consistent with full employment GDP).
Consider the contributions by Kydland and Prescott – that is, show how the policy makers have an
incentive to cheat by stimulating aggregate demand to stimulate GDP beyond its potential. Label this
point B. Point B is a short-run equilibrium and is not consistent with a long run equilibrium since we
assume that potential output is driven by supply side factors.18 Now let wages rise and show what
happens to equilibrium GDP and the equilibrium price level. Label this point as point C. Which do
you prefer – point A or point C. Use the loss function that we developed in class to buttress your
argument.
18
Most if not all economists agree with the notion that potential output is driven by the production function
which is typically a function of total factor productivity, labor, capital, and land resources.
25
2. The second part of Kydland and Prescott’s contribution deals with sources of the
business cycle. As stated in the article, this part of their contribution is “contentious.”
Show and explain how, using the aggregate demand / aggregate supply model, how
business cycles can be explained by introducing productivity shocks. What data would
you look at to determine whether or not their analysis was consistent with the facts?
Finally, explain other possible short comings of their analysis.
26
The 1970’s and Stagflation
Stagflation: An economic state characterized by lower output (real GDP) and higher prices (inflation).
Oil Shocks: A Huge jump in price of oil caused a fall in AS and resulted in stagflation. Policy makers were
faced with a dilemma: (1) they could combat inflation and allow UR to rise or (2) they could combat UR
and allow inflation to rise. Policymakers must decide which ‘evil’ they deem more important.
Show Stagflation in an AS-AD framework below
Overheating example – do below being sure to discuss the policy implications! Be sure to discuss the key
to preventing the economy from overheating (hint – driving the car example).
27
New Economy Example: Use the space below to depict the new economy in an AS – AD framework.
28
Back to Stagflation Example – introduction of the misery index, and why is
stagflation the worst of both worlds?
Misery Index: A misery index is simply the summation of the inflation rate and
unemployment rate. As we know, in a stagflation environment, both inflation and
unemployment rates are high.
The Misery Index – Source – FRED – Federal Reserve Bank of St. Louis
25.0
20.0
15.0
Series1
10.0
5.0
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
Jan-78
Jan-76
Jan-74
Jan-72
Jan-70
0.0
Note how “miserable” we were in the 1970s. These are the two episodes of stagflation.
29
The Fed’s Loss Function and Hawks vs. Doves
Inflation Hawk: Policymaker who is very concerned about inflation, more so than any of
the other
Inflation Dove: Policymaker who is less concerned about inflation and more concerned
about other goals of the fed such as full employment and GDP growth.
The Fed’s Loss Function
L = - [α (π-π*)2 + β ( y-y*)2 ]
OR
L = -[α (π-π*)2 + β ( UR - NAIRU)2 ]
Where:
π = actual inflation rate
π* = target or “optimal” inflation rate
y = actual gdp growth
y*= potential (or optimal) gdp growth
α = parameter measuring the degree of “hawkishnish”
β = parameter measuring the degree of “dovishness”
UR = actual unemployment rate
NAIRU = non-accelerating inflation rate of unemployment
Be familiar with the following terms when interpreting the Fed’s loss function:
Inflation Targeting
Core PCE
Alpha
Beta
Stagflation
Hawks
Doves
Discuss Paul Volcker and his behavior during the second oil shock.
Discuss the reputation that Chairman Bernanke has acquired and why.
Be very clear about the 180 degree difference in policy between hawks and doves
in a stagflation environment. That is, in a stagflation environment, hawks and
doves would most definitely disagree.
30
The Fed: Are they currently Hawkish or Dovish? Most people believe that if you are
considering only the federal funds target, a target at 3% or below would be considered as
“easy” policy, anywhere between 3 and 5% would be considered neutral, and above 5%
would be considered “tight” policy.
The Taylor Rule (use the space below to write out and explain the Taylor Rule)
31
Real vs nominal interest rates; the Fisher equation
Determining Real Rate of Interest
Example 1:
2005 basket
$1000
2006 basket
$1000
1. Determinants of whether to buy the 2005 basket or wait and buy the 2006
basket.
Initial Conditions:
a. Inflation Expectation ( πe ) = 0
b. Nominal Interest Rate ( i ) = 0
c. Real rate of interest (r) = i - πe
d. 0 (r) = 0 (i) - 0 (πe)
e. A person expecting a zero real return from saving would most
likely consume today rather than saving for the future.
Example 2:
2005 basket
$1000
2006 basket
1000e
50
New Conditions
a. Inflation Expectation ( πe ) = 0
b. Nominal Interest Rate ( i ) = 5%
c. Real rate of interest (r) = i - πe
d. 5 (r) = 5 (i) - 0 (πe)
e. A person expecting a positive real return from saving would
most likely save today so that they can consume 5% more of real goods
and services next year.
32
Example 3:
2005 basket
$1000
2006 basket
$1100e
worth $50 (Real)
New Conditions
a. Inflation Expectation ( πe ) = 10%
b. Nominal Interest Rate ( i ) = 5%
c. Real rate of interest (r) = i - πe
d. -5% (r) = 5 (i) - 10 (πe)
e. A person expecting a negative real return from saving would
most likely consume now, because if they save, they can consume
less in the future.
The Fisher Effect
Given the change from example 2 to example 3, bonds have now become much less
attractive. Given the decrease in interest in these bonds, the bond price will fall and the
interest rate will rise (more on this in class). If the equilibrium real return is 5% = r, then
nominal interest rates on bonds would have to rise to 15% to compensate the saver for 1)
expected inflation of 10% and 2) return the saver the equilibrium real return of 5%. The
Fisher effect is the idea that higher expected inflation will cause nominal interest rates to
rise.
33
Chapter 2 – Financial Markets
Financial Markets – We will discuss financial markets every Monday until we are
done. Included in our discussions will be lecture notes, articles, exercises using the
Stock Trak Global Portfolio Simulation website, as well as previous HW and exam
questions.
To truly understand financial markets and ‘talk the talk,’ you will be required to
understand a plethora of jargon. Remember, I am here to answer all your questions, so
don’t be shy. The last thing we need is for you to not to understand something because of
jargon. Before getting started, it would be helpful to think of financial markets as a giant
poker game where it is ‘dealer’s choice.’ There are many different poker games out there
and when you start playing, everybody has an equal chance of winning, that is, it is a fair
game. Financial markets are similar in that there are many bets one can make and
everyone has the same chance as winning (making a capital gain) and losing (suffer a
capital loss). Another way to state this is that there is no free money to be made in
financial markets and we will get much deeper into this phenomenon a little later in the
course.19
Glass half full or empty (Bulls vs. Bears).
As mentioned above, there are many bets you can make in the financial markets.20 Before
deciding on what particular bet to make, you essentially need to decide if you are
optimistic (Bullish) or pessimistic (Bearish) as it pertains to the ‘chosen’ asset’s price.
Bulls make money when prices rise and lose when prices fall. Conversely, bears make
money when prices fall and lose money when prices rise. After you establish whether
your are bullish or bearish, you can chose any of the ‘games’ or ‘bets’ that follow, always
remembering, a) there is no free money out there and 2) different bets have varying
amounts of risked attached to them.
Stocks: Long vs. Short
A US Common stock represents partial equity in the company whose name it bears.
Going long, that is, buying and holding shares of stock is probably the simplest (and most
familiar) investment one could make. The idea is to buy (relatively) low and sell high,
reaping what is referred to as a capital gain. Mutual funds are primarily comprised of
long positions in common stock. In taking a long position, the investor is betting
(hoping) that the stock price (or stock market index) will rise.
19
For those of you familiar with finance, this concept is known as the efficient market theory.
When state the word financial markets, we are typically referring to three very large markets:1) the Bond
market; 2) the Stock (equity) market, and 3) the Foreign Exchange market.
20
34
Example: Use the space below: Taking a long position (buying 10 shares) in IBM
stock:
In contrast to going long, an investor can go “short” on a stock and therefore benefit if the
relevant stock price falls (A bearish position). Shorting a stock involves borrowing
shares from a creditor (e.g., JP Morgan) and selling them immediately. The key to
understanding how shorting stocks works is to recognize that your debt is in stocks and
not cash. For example, if I short one hundred shares of IBM stock, I borrow 100 shares
of stock from a creditor and it is 100 shares of stock that I owe my creditor (excluding
transactions fees)21. The idea is that once the price has fallen, I can buy the (borrowed)
shares back for less money than I received when I sold them. Thus, if the stock does fall
you pocket the difference. If the stock price rises instead and stays relatively high, then
you will (eventually) be forced to buy the stock back at a higher price than you sold it for
and will thus suffer a capital loss.
Example: Use the space below: Shorting IBM stock (shorting 10 shares):
In one sense, shorting a stock is more risky than going long because it exposes the
investor to the possibility of larger losses. For example, if I short shares of a small
biotech company which then announces a drug approval by the FDA tripling its share
price, I will lose 200% overnight.22 Conversely, the worst-case scenario with long
investments is a loss of 100%, such as occurred when Enron announced accounting
scandals and its stock price went to zero.
Throughout this course, we will typically ‘assume away’ transactions costs in our numerical calculations
and analyses.
22
For example, If I short 100 shares when the price is $10 and the price subsequently rises (triples) to $30,
it would cost me $3000 (buying 100 shares at $30 and returning them to my creditor) to close my position.
The initial value of my ‘investment’ was $1000 (100 shares times $10) so the loss is 200% (($1000 $3000)/$1000) x 100. You will be required to calculate rates of return throughout this course.
21
35
Long vs. Short positions on Bonds
Throughout the semester, we will constantly exploit the inverse relationship between the
price of bonds and the yield or interest rate on bonds.
Do the “Chud Bond” Example in the space below emphasizing this inverse
relationship between the price of bonds and the interest rate on bonds (an Asian
financial crisis example).
You would take a long position on bonds if you expect prices to go up, same reasoning as
in stocks (above). Saying the same thing a little differently, you would take a long
position on bonds if you expect lower interest rates in the future. As we will see
throughout the semester, expected Federal Reserve policy (i.e., what the Fed may or may
not do in the future) plays a critical role in the determination of bond prices and thus
interest rates. Investors are constantly looking for clues that will aid them in this regard
and naturally, the continuous stream of incoming economic data is scrutinized for
possible clues. For example, if the CPI (consumer price index) report came out and
suggested major inflationary pressures that were not expected prior to the report, then
investors would immediately expect the Fed to be more hawkish in the future, and thus,
interest rates would be expected to be higher in the future.23 Exploiting the inverse
relationship between bond prices and interest rates, the previous statement can be stated
as “due to the CPI report, investors expect lower bond prices in the future and thus,
investors who currently have a short position in bonds will be the winners while those
investors who have a long position will be the losers. We will be evaluating the impact
of NEWS on the asset markets throughout the semester with NEWS being defined as the
“unexpected!” For example, if the consumer price index is expected to rise by .2% and
the actual number is .2%, then there is no NEWS since expectations were exactly correct.
Naturally, expectations are usually not correct so NEWS is virtually an everyday
experience.
23
Hawkish refers to the Fed aggressively fighting inflation by raising interest rates to slow down aggregate
demand. The opposite of hawkish is dovish and refers to the Fed being soft on inflation. An inflation dove
typically worries more about employment and economic growth and less about inflation; the opposite can
be said about an inflation hawk. These terms will be used throughout the semester, especially when we
consider the Fed’s loss function and the Taylor rule.
36
Long vs. Short positions on Foreign Exchange
If you go long on the dollar, that means you are hoping the dollar gets stronger relative to
the currency that you chose or a basket of currencies as in a dollar index. For example, if
I go long on the dollar relative to the Euro, then I will profit if the dollar get stronger
relative to the Euro and lose money if the dollar weakens relative to the Euro. If you
think the dollar is going to weaken, then you should take a short position on the dollar.
Example: In the space below, do an example of taking a long position on the euro vs.
the US dollar.
The currency market is probably the hardest to predict of the three asset markets and we
will keep an ‘eye’ on the currency markets throughout the semester.
Options
Options are contracts giving the owner the right to buy (call option) or the right to sell
(put option) shares of stock at a predetermined (strike) price. One call option typically
gives the owner the right to buy 100 shares of the underlying security for the strike price
stated on the contract. Buying calls is considered bullish because you profit when the
underlying stock price rises. A call option is “in the money” when the strike price is
below the (current) spot price. In such a case, the price at which you can buy the stock,
i.e., the strike price, is less than the price that you can sell the stock, the spot price, so
exercising the option would be profitable.
Example: Use the space below to do an IBM example on calls (a long position;
bullish).
37
A put option is the exact opposite (and is thus bearish) and gives the owner the right to
sell the underlying security at the strike price. Put options are in the money when the
spot price is below the strike price. In this case, the owner could exercise the put by
buying the stock at the relatively low spot price and selling the stock at the strike price,
since this is exactly what a put option allows you to do.
Example: Use the space below to do an IBM example on puts (a short position;
bearish).
Option prices are quoted in premium-per-share. The premium is the price you pay for the
option contract. Recall that an option contract allows you to buy or sell a specified
quantity of an asset during a specified time period (i.e., they expire). To find the actual
cost of an option (excluding fees and other possible transactions costs), multiply the
quoted premium by 100. We will discuss the specific factors that determine option
premiums during class. We will also understand why options are typically not exercised,
they are bought and sold much like shares of stock or bonds. The example problem on
options that follows will help us understand this entire paragraph.
Futures
A futures contract is an obligation to deliver or receive a financial asset or commodity on
a predetermined date for a stated price.24 Futures contracts exist for everything from pork
bellies to interest rates. Futures contracts are generally preferred to forward contracts
because they are standardized and for the most part, more liquid. Interest rate futures are
always denominated by a face value of $100,000; other commodities have standardized
qualities as well. Futures are often used as a hedge (insurance) against unwanted price
movements. For example, a farmer who produces wheat would want to insure against a
low price at harvest time by selling wheat futures to lock in a price for his/her wheat. By
selling a wheat futures contract, the farmer is obligated to deliver a specified quantity of
wheat at a specified future time.25 When the wheat is harvested, he/she must deliver it at
the price as described by the futures contract. In much the same way, a baker who uses
wheat can ensure against a high price at harvest time by purchasing wheat futures, thus
locking in a price for this vital input. In this sense, the baker is hedging (insuring) against
a high price of wheat at harvest time. As you can see, there is a ‘natural market’ that
develops here; The farmer insuring against low prices at harvest time, and a baker
insuring against high prices at harvest time.
24
One major difference between options and futures is that futures contract require you to close your
position where as options do not (i.e., options can expire without any action between the buyer and seller).
25
As in at harvest time. In the real world, the standardized quantity for a futures wheat contract is 5,000
bushels!
38
Speculators operate in the futures market as well tending to improve the liquidity to the
futures market. We will discuss speculators in the futures market when we do the
problem that follows.
To trade futures, an investor must keep approximately 10% of the value of the contract in
his account as margin. Futures accounts are marked to market daily meaning that if
your account falls below margin, you must add funds to the account immediately.
Conversely, if you make money, cash is added to your account at the close of trading
each day. This property of the futures market give accountants headaches and as a result,
the relatively new futures options markets has blossomed.
Futures contacts are very risky, since you can place a very large bet for a relatively small
amount of money. If there are significant changes in the value of your futures contract,
the the gains/losses can easily exceed 100% in a short period of time.
Futures Options
A futures option is simply the option to buy (a call) or sell (a put) a specified quantity of
commodity at a predetermined price by the expiration date. These options trade on
exchanges just like regular stocks or options and their prices, therefore, are marketdetermined. Advantages of futures options over futures are:
a) Futures options preserve the possibility of profits while limiting potential losses to the
price of the option. That is, the most you can lose is what you paid for the option
(referred to as the premium).
b) Futures options do not require daily settlement via a margin account and thus are
much easier to handle from an accounting standpoint.
While futures expose investors to virtually infinite risk, the most one can lose with the
purchase of a futures option is the cost of that option (i.e., the premium). As with stock
options, if the contract is not “in the money,” the contract will not be exercised and no
additional losses will be incurred.
39
Terms to be familiar with (not in any particular order):
1. Options – calls, puts.
2. Derivatives – what does this term mean and why?
3. Shorting stocks and short covering.
4. Long vs. Short positions.
5. NEWS.
6. Futures.
7. Closing your position.
8. Hedging vs Speculating
9. Bulls vs. Bears.
10. Exercise.
11. In the money.
12. Rally (apply to all three of the asset markets).
13. Spot price.
14. Zero Sum game.
15. Strike price.
16. Expiration date.
17. Futures options.
18. Determination of option premium.
19. Covered vs. Naked calls/puts.
20. Writing options.
21. Risk.
22. Expected return.
23. Liquidity.
Practice Questions
1. a) Suppose you bought (took a long position) 10 shares of IBM stock at a (previous)
spot price of $100 and the current IBM spot price is $95. If you closed your position,
how much money would you make/lose (assume away all transactions costs)? Show al
work.
b) Suppose alternatively that you took a short position by shorting 10 shares of IBM
(assume same price change as in 1. a) above. How much money would you make/lose if
you closed your position (cover your short)? Explain in detail and show all work.
40
c) Given either position, what would determine whether or not you would close your
position? Again, explain in detail.
2. Previous HW assignment from Spring 2006
(15 points total) Use the following 3 tables to answer the questions that follow. In this
example, you are bearish on Best Buy (BBY). We are going to examine and compare
two bearish bets. We assume away all transactions costs and as always, use the ‘last sale’
column, i.e., the premium for your calculations.
TABLE 1
BBY
46.20 -4.16
Sep 13, 2005 @ 10:29 ET (Data 20 Minutes Delayed)
Bid N/A Ask N/A Size N/AxN/A Vol 8587300
Calls
Last
Sale
Bid
Ask
Vol
Open
Int
Puts
Last
Sale
05 Sep 43.375 (BXJ IU-E)
4.40
pc
2.80
2.95
0
3119
05 Sep 43.375 (BXJ UU-E)
0.10
05 Sep 45.00 (BBY II-E)
05 Sep 46.625 (BXJ IV-E)
1.55
-3.65
1.40
1.55
86
826
05 Sep 45.00 (BBY UI-E)
0.55
-3.65
0.45
0.50
83
5966
05 Sep 46.625 (BXJ UV-E)
05 Sep 47.50 (BBY IW-E)
0.25
-3.15
0.15
0.25
266
6145
05 Oct 42.50 (BBY JV-E)
6.90
pc
4.30
4.50
0
27
05 Oct 45.00 (BBY JI-E)
2.80
-1.60
2.50
2.60
40
813
05 Oct 47.50 (BBY JW-E)
1.25
-2.95
1.20
1.30
205
05 Oct 50.00 (BBY JJ-E)
0.50
-2.05
0.50
0.55
109
Net
Bid
Ask
Vol
Open
Int
pc
0.10
0.15
0
9902
0.35
+0.15
0.30
0.40
761
9084
0.85
+0.45
0.90
1.00
81
5637
05 Sep 47.50 (BBY UW-E)
1.50
+0.95
1.50
1.60
441
5594
05 Oct 42.50 (BBY VV-E)
0.60
+0.20
0.60
0.70
14
1311
05 Oct 45.00 (BBY VI-E)
1.25
+0.45
1.30
1.40
216
1834
1382
05 Oct 47.50 (BBY VW-E)
2.50
+1.20
2.45
2.60
65
4461
8526
05 Oct 50.00 (BBY VJ-E)
4.10
+1.95
4.20
4.40
42
1127
Net
TABLE 2
BBY
45.29 -5.07
Sep 13, 2005 @ 15:11 ET (Data 20 Minutes Delayed)
Bid N/A Ask N/A Size N/AxN/A Vol 24252700
Calls
Last
Sale
Net
Bid
Ask
Vol
Open
Int
Puts
Last
Sale
Net
Bid
Ask
Vol
Open
Int
05 Sep 43.375 (BXJ IU-E)
2.10
-2.30
2.00
2.10
376
3119
05 Sep 43.375 (BXJ UU-E)
0.15
+0.05
0.10
05 Sep 45.00 (BBY II-E)
0.85
-4.35
0.75
0.85
955
826
05 Sep 45.00 (BBY UI-E)
0.50
+0.30
0.45
0.20
765
9902
0.50
1388
9084
05 Sep 46.625 (BXJ IV-E)
0.20
-4.00
0.15
0.20
267
5966
05 Sep 46.625 (BXJ UV-E)
1.35
+0.95
05 Sep 47.50 (BBY IW-E)
0.10
-3.30
0.05
0.10
275
6145
05 Sep 47.50 (BBY UW-E)
2.10
+1.55
1.45
1.55
247
5637
2.20
2.30
678
05 Oct 42.50 (BBY JV-E)
3.50
-3.40
3.60
3.80
5
27
05 Oct 42.50 (BBY VV-E)
0.75
5594
+0.35
0.75
0.85
103
1311
05 Oct 45.00 (BBY JI-E)
2.00
-2.40
1.95
2.05
326
813
05 Oct 45.00 (BBY VI-E)
05 Oct 47.50 (BBY JW-E)
0.95
-3.25
0.90
0.95
1021
1382
05 Oct 47.50 (BBY VW-E)
1.65
+0.85
1.65
1.70
383
1834
2.90
+1.60
3.00
3.10
148
05 Oct 50.00 (BBY JJ-E)
0.35
-2.20
0.35
0.40
458
8526
05 Oct 50.00 (BBY VJ-E)
4461
4.70
+2.55
4.90
5.10
185
1127
41
TABLE 3
BBY
Oct 01, 2005 @ 07:22 ET (Data 20 Minutes Delayed)
43.53 +0.49
Bid N/A Ask N/A Size N/AxN/A Vol 3075600
Calls
Last
Open
Net Bid Ask Vol
Puts
Sale
Int
Last
Open
Net Bid Ask Vol
Sale
Int
05 Oct 40.00 (BBY JH-E)
4.10 +1.35 3.70 3.90 105 1004 05 Oct 40.00 (BBY VH-E)
0.30
05 Oct 42.50 (BBY JV-E)
1.65 +0.50 1.75 1.85
0.60 -0.65 0.60 0.70 128 8718
05 Oct 45.00 (BBY JI-E)
0.70 +0.40 0.50 0.60 313 7907 05 Oct 45.00 (BBY VI-E)
8 6866 05 Oct 42.50 (BBY VV-E)
pc 0.15 0.25
0 7023
1.85 -0.75 1.85 1.95 22 4167
05 Oct 47.50 (BBY JW-E) 0.15
-- 0.10 0.15 303 5847 05 Oct 47.50 (BBY VW-E) 3.50 -1.00 3.90 4.10 26 4036
05 Nov 40.00 (BBY KH-E) 4.00
pc 4.30 4.50
0 3579 05 Nov 40.00 (BBY WH-E) 0.55 -0.45 0.60 0.70 10 875
05 Nov 42.50 (BBY KV-E) 2.80 +0.80 2.55 2.65 45 4400 05 Nov 42.50 (BBY WV-E) 1.25 -0.40 1.30 1.40 65 685
05 Nov 45.00 (BBY KI-E) 1.45 +0.30 1.25 1.40 25 3203 05 Nov 45.00 (BBY WI-E) 2.30 -0.65 2.50 2.60 64 330
05 Nov 47.50 (BBY KW-E) 0.60 +0.15 0.50 0.60
8 1059 05 Nov 47.50 (BBY WW-E) 4.20 -0.90 4.20 4.40 28
11
It is Sept 13 at 10:29 am (TABLE 1). You are thinking that Best Buy is going down due
to hurricane related stuff including high oil prices. You have $2,500 to play the game and
you are going to spend it all on BBY put options. You are looking at Oct 45 puts and Oct
47.50 puts.
a) (2 points) Why the difference in the premiums on these two options (use Table 1)? Be
specific.
b) (2 points) Suppose you decided to use the entire $2,500 to purchase the Oct 45 puts.
How many put options could you buy and what would they collectively, give you the
right to do (we are still using Table 1)?
c) (3 points) It is now October 1 (Table 3) and you decided to sell your Oct 45 puts.
What is your profit/loss? What is your rate of return? Please show all your calculations.
42
d) (2 points) Instead of purchasing the Oct 45 puts you decide to use all $2,500 to
purchase the October 47.50 puts (again, on Sept 13 at 10:29 am – Table 1). How many
Oct 47.50 puts could you buy and what would they, collectively, give you the right to do?
e) (2 points) It is now October 1 (Table 3) and you decided to sell your October 47.50
puts. What is your profit/loss and your rate of return? Please show all your calculations.
f) (2 points) Given that your profit / loss is different depending on your choice of puts,
which selection of put options gave you a higher return (i.e., compare part c) with part
e))?
g) (2 points) Now consider Table 2. Since hindsight is 20 / 20, would it have been better
in terms of profits and/or returns if you would have sold your options later on September
13 (Table 2) rather than waiting until 10/1 (Table 3)? Why or why not, explain.
43
3. Previous HW assignment from Spring 2006
(15 points total) Suppose you are a weaver and you need 10,000 pounds of cotton to
make handkerchiefs. Harvest time is six months from now and you want to lock in a
price per lb now via a futures contract. Suppose you can make an agreement, that is,
enter into a futures contract for 10,000 lbs with a cotton farmer with an agreed upon price
of $1.00 lb (which happens to be the current spot price).
a) (2 points) Explain the terminology of the transaction – that is, what exactly are you
doing and why: what is the farmer doing and why?
b) (2 points) Now suppose, due to a trade war and a great growing season, cotton prices
plunge to 50 cents ($0.50) per pound at harvest time. Who looks smart for acquiring the
futures contract, the cotton farmer or the weaver? Explain.
c) (3 points) Now, let’s assume that they are both speculators. Plot the profit function
(futures profit functions) for the speculator cotton farmer (in one graph) and the
speculator weaver (in another graph). Locate the profit or loss for each with a label of
point A (where the price equals $0.50). Please use the space below for your diagram.
44
d) (3 points) Now assume that instead that the speculators play the futures options
market. In particular, the speculator cotton farmer buys a futures options put for 10,000
lbs of cotton for $1000 (strike price = $1.00 lb) and the speculator weaver buys a futures
options call for 10,000 lbs of cotton for $1000 (strike price = $1.00 lb). Assume that the
price per pound plunges to 50 cents ($0.50) as before and that the futures options expire
at harvest time. Add the futures option profit function for each speculator to your diagram
above. Locate the profit or loss for both players in the futures options game as point B.
Be sure to label your diagram with all the specific numbers that apply. Which option is
“in the money?”
e) (4 points) Are these results consistent with a zero sum game (hint, there are four
players here)? Explain.
45
Portfolio Allocation and the demand for assets
There are three main determinants of asset pricing:
1) Expected return: The higher the expected return of the asset, all else constant, the
higher the price of the asset. Naturally, we will discuss at length the factors that
influence the expected return of the asset(s) throughout the course. I do want to
mention at this point how important expectations and changes in expectations are in
terms of determining not only asset prices, but also, aggregate economic activity.
Asset price = f (Rete) :
+
{stated as “the asset price is a positive (+) function (f) of it’s expected return (Rete), all
else constant}
2) Liquidity: Liquidity is an attractive quality in any asset and a highly liquid asset has
three qualities: 1) it is easy (low cost) to convert the asset into money where money is
defined as transactions money; 2) it can be converted to money quickly and 3) the
amount that it is converted to is representative of its fundamental value (i.e., I can sell my
house very quickly and easily for $5, but that doesn’t mean it is liquid!). Typically, the
more liquid the asset, the lower the return. Take money, typically considered to be the
most liquid asset of all. Money earns a nominal return of zero and a real return equal to
the ‘negative’ of the inflation rate.26
Liquidity is especially attractive in a highly uncertain environment. When we discuss
financial crises and shocks like 9/11, we will see the impact on financial markets when
investors demand more liquid assets. US Treasuries are often considered very liquid and
thus the term: “rush to the safe haven of US Treasuries.” The safe haven refers naturally
to the perceived zero default risk quality of US Treasuries.
Asset price = f (Liq) :
+
{stated as “the asset price is a positive (+) function (f) of it’s liquidity (Liq), all else
constant}
3) Risk: The more risky the asset, the more uncertain as to the assets’ return. Risk arises
for a variety of reasons and we assume that all else equal, investors prefer assets with less
risk (i.e., on average, investors are risk averse). We also note that risk and expected return
26
Suppose inflation over a year is 10% and I keep $100 in my pocket. That $100 next year would be able
to purchase 10% less in real goods and services given the 10% rise in the general price level that has
occurred over the year.
46
are related – typically, the higher the risk, the higher the expected return (investors
require a higher expected return to take on the higher risk).
Asset price = f (Risk) :
{stated as “the asset price is a negative (-) function (f) of it’s Risk, all else constant}
Stock Price Determination
As most of us could gather, the obvious driving force underlying any the price of any
stock is the expected future stream of profits or earnings (earnings and profits are used
interchangeably). We need to be more specific, it is the present value (PV) of current and
future earnings that matter. We all should recall that the present value of say $1,000
today is larger than the present value of $1,000 ten years from now. But how much
larger? The answer depends on the expected nominal interest rate to prevail over the next
ten years. Let’s make life simple, let us suppose that the interest rate over the next ten
years will be 10% year in and year out. In this case, given these assumptions, the PV of
$1,000 ten years from now would be:
PV1000 = $1,000/(1 + 0.10)10 = $ 385.54
What does $385.54 represent? The answer is that if we take $385.54 and invest it today
at a 10% annual return and take the principal and interest and continue rolling it over for
10 years, at the end of the 10th year, we would have $1,000. An equivalent way of
thinking about this is, and the way most relevant for understanding how stock prices are
determined is the following: Given the above conditions, I would be willing to pay
$385.54 today, to receive $1,000 ten years from now. In what follows, the $1,000 in this
example would be the “expected profits” of the firm ten years from now. These expected
profits are continuously changing given the continuous NEWS that investors digest and
process on a day to day basis.
In terms of stock price determination, investors form expectations as to the future profits
of any particular firm as well as the expected path of interest rates, since together, they
determine the present value of the firm. Similar to the above, the present value of a firm
can be thought of as the most investors would be willing to pay for the firm today, to
have the ownership rights to all the current and future profits expected in the future.
When we divide the present value of the firm by the number of shares of stock
outstanding, we arrive at the price of the stock. Before getting into more specifics, please
read the following summation.
47
Three major factors to keep in mind when considering stock
price determination
1) Stock prices are driven by expectations and changes in expectations. Just about
everything influences expectations and these changes in expectations are reflected
immediately in the relevant stock price.27
2) Stock prices are positively related to expected earnings and expected earnings nearer
to the present have a stronger influence on stock prices than do the same expected
earnings further out into the future. For example, the present value of $10,000 in
expected earnings 2 years from now is larger than the present value of $10,000 in
expected earnings 10 years from now (assuming away zero interest rates)28
3) Stock Prices are typically negatively related to the expected path of interest rates. The
expected path of interest rates is so important in financial markets, not to mention,
aggregate economic activity. Many investors spend much of their time trying to figure
out what the Federal Reserve may or may not do. Interest rates also change for reasons
not directly related to Fed policy, and a big portion of this class revolves around interest
rate determination. For the present, we need to understand why lower interest rates are
‘typically’ good for stocks. First, the present value of future profits rises the lower the
expected path of interest rates. Let’s return to our example above. It was shown that the
PV of $1,000 ten years from now, assuming 10% interest rates year in and year out, was:
PV1000 = $1,000/(1 + 0.10)10 = $ 385.54
Now let’s let the expected path of interest rates be 5% year in and year out. What is the
PV of $1,000 ten years from now given this lower expected path of interest rates?
PV1000 = $1,000/(1 + 0.05)10 = $ 613.91
So if the expected path of interest rates fall, all else constant, that should be good for
stocks as the PV of the firm will rise.
Second, we can not ignore the influence of the change in the expected path of interest
rates on expected profits. This influence is very real but also very hard to analyze and
therefore, the context must be taken into account. For example, on one hand, lower
interest rates in the future should stimulate economic activity and according to this
version of the story, should result in higher expected profits. On the other hand, if people
expect lower interest rates due to a poorly performing economy, then perhaps expected
profits will fall instead of rise. So the influence of lower expected interest rates on the
27
This notion applies to bond and foreign exchange markets as well.
In addition to the PV, near term expected profits have less uncertainty than expected profits well into the
future, so when the expected profits change, it is the nearer term(s) of expected profits that have the most
influence on the stock price.
28
48
expectations of future profits is ambiguous, and thus, needs to be examined on a case by
case basis.
Numerical Example and some Terminology
The stock price of any firm is equal to the (expected) present value of the firm (market
cap) divided by the number of shares outstanding. Any factor, and there are many, that
changes the expected present value of the firm, will change that stock price.29
The assumption (in the numerical example that follows) is that this firm falls off the face
of the earth after three years, a more realistic example would include many more terms
(an infinite amount!).
e
e
e

Earnings 1 Earnings 2 Earnings 3
Present Value of Compay 



1  i1 1
1  i2e 2
1  i3e 3
e  an expected value
Present Value of Company  Market Cap
Price per Share 
Market Cap
# of Shares Outstandin g
Example:
Year
Exp. Earnings
Exp. 1 yr Interest
Rate
MarketCap 
Company ABC (10,000 shares outstanding)
1
2
$15,000
$50,000
0.03
0.04
3
$100,000
0.05
$15,000 $50,000 $100,000


1  .031 1  .042 1  .053
 $147,175
$147,175
10,000
Pr ice  per  share  $14.72
MarketCap /# Shares 
Price to earnings ratio (PE ratio): The price to earnings ratio is often used by
investors as a guidepost as to whether a stock is “overvalued” or “undervalued.”
29
Psychology also plays a role here. How people feel, waves of optimism and pessimism certainly move
stocks, and a strand of finance referred to as behavioral finance will be addressed at a later time. Needless
to say, when we add psychology to the ‘equation,’ analysis becomes that much more difficult as well as
less concrete in nature.
49
Given that stock prices are determined by expectations of the future, we NEVER
know whether a stock price is overvalued, undervalued, or valued ‘just right.’30
The price to earning ratio can be calculated in two equivalent ways:
1) Take the market cap, which is equal to the number of shares outstanding times the
current price of the stock and divide it by current year earnings. From the example
above:
PE ratio = $147,175 / $15,000 = 9.81
2) Take the price per share and divide it by current year earnings per share:
PE ratio = $14.72 / $1.50 = 9.81
We can now do some exercises:
1) Suppose the Federal Reserve makes a dovish announcement and as a result, investors
expect the path of short term interest rates to be steady at 3% (as opposed to previous
expectations over the three year life of the firm of 3, 4, and 5% respectively).
Exercise: What will happen to the Stock Price?31
Exercise: What will happen to the PE ratio?
2) Suppose the CEO of Company ABC makes a statement that the company’s expected
earnings are now lower than previously expected (i.e., a pessimistic outlook) so that
investors now expect profits to be ‘flat’ at $15,000 for the next three years (assume
the initial expected path of interest rates of 3, 4, and 5% in year 1, 2, and 3
respectively).
Exercise: What will happen to the Stock Price?
In December of 1996, Alan Greenspan stated that investors were “irrationally exuberant,” implying that
investors were erroneously optimistic about future profits. Another way to state the same thing is that a
bubble had formed in the stock market! Alan Greenspan was heavily criticized for this comment and truly
regrets saying it. The moral of the story is that we don’t know when stocks are overvalued or undervalued
and thus, major figureheads should refrain from giving their personal opinion. The following statement is
believed by just about everyone in finance and economics: “We never know if there is an asset market
bubble until the bubble breaks.”
31
We are holding expected earnings constant in this example.
30
50
Exercise: What will happen to the PE ratio?
3) Give two specific reasons why the PE ratio would be high for a firm and comment on
the type of firm that may have a high PE ratio. Finally, does a high PE ratio imply
that the firm is over valued? Why or why not?
The Optimal Forecast and Rational Expectations.
Example 1: Rational Expectations and a Question Before You Hand in Your Exam!
When I was at Grad School here at PSU, a professor told a story that I believe really
clarifies exactly what we mean by rational expectations. Suppose I would say to the class
before anyone handed in their exam (assume it is a multiple choice exam):
“Put an asterisk next to the three questions that you think you missed”
So let’s think about this for a moment……. which questions would you pick? The
answer is that if you have rational expectations formation, you should not pick any!
Why?? If you pick a question that you think you missed, then change the answer! Of
course I know a lot of you are thinking that well…. some questions are harder than others
and I will simply choose the three hardest questions! That is fine and consistent with
rational expectations, but that is not admitting that you think you missed them because if
you think you missed it, again, you would change the answer. So again, if I asked you
how many questions you think you missed, your answer should be zero!
Another interesting and useful feature of this example is the concept of a probability
distribution – some questions probably fall into the ‘no brainer’ category and thus, you
are quite certain that you got them correct; some are in the easy but not that easy, etc. As
we shall see, probability distributions and the associated uncertainty plays a critical role
in financial markets and the economy.
Example 2: Using Rational Expectations on Your Drive to Work Each Day
Suppose you live in Port Matilda and work in State College. Suppose also that you do
not want to arrive at work “too” early and you don’t want to arrive at work “too” late.
Suppose through experience, you estimate the commute to be 15 minutes and thus leave
51
15 minutes before you are scheduled to work.32 Suppose you begin work at 8 am and
thus you leave at 7:45 am.
Questions:
1) Would you expect to get to work at starting time each and everyday?
2) Would you actually get to work at exactly the same time?
3) Is your forecast of the time it takes to get to work optimal? Why or why not?
Consider the following two scenarios:
a) One the way to work you get stuck in traffic due to an accident, somebody hit a
deer and you end up getting to work 15 minutes late!
Question: Would you change your forecast on how long it takes to get to work and
would this forecast be optimal?
b) The state begins construction (on the road you travel) and you are 15 minutes
late for work. You learn that the construction is going to last for 6 months. Would
you change your forecast on how long it takes to get to work and would this forecast
be optimal?
Let’s define the forecast error (FE) as the starting time (8 am) minus (-) the actual
arrival time. If the actual arrival time is 8am, then the forecast error equals zero; if
the arrival time is not 8 am, then the FE is non-zero. What are the properties of this
forecast error (there are three of them)?
a.
b.
c.
Let’s assume that your employer is okay with you being a little late or a little early and thus, as long as
you are to work on time, on average, all is well.
32
52
Predicting Tomorrow’s Stock Price and the Efficient Market
Theory
In the driving to work example above, we had the incentive to obtain an optimal forecast
for the commute and thus, we used all the relevant information available to formulate that
optimal forecast. For example, if it snowed all night and you believed the roads are likely
to be slippery, you would use that relevant and available information immediately and
incorporate (process the information) it into your forecast of the time it will take to get to
work. In terms of jargon, we would say you were irrational if you did not account for the
snowfall.
Naturally, any investor would love to be able to predict the future, because if you can
predict future movements in asset prices, you could place the appropriate bet(s) and make
lots of money! The example that follows applies to stocks, but the same line of reasoning
can be applied to the bond and foreign exchange markets.
Suppose you were to try to predict tomorrow’s stock price today. Let us define the
information set available to you today as Ωt. Naturally, Ωt contains ALL information
that is available at time t, where the subscript t stands for today, the subscript t+1 stands
for tomorrow (next period in general).
We can write the following:
St+1 = f (Ωt):
{stated as: “Tomorrow’s stock price is a function of the (entire) information set available
today.”}
Naturally, we would want to use all the relevant information that is currently available in
predicting an asset price. Another way to say this is that it would be irrational if we did
not use all the relevant and available information that was available today (recall the
drive to work and ignoring the snowfall example). In fact, rational expectations
formation simply means that agents use all the information that is available today in
making their forecasts and thus, the forecast is optimal.
Predicting stock prices is very similar in that you rationally use all the relevant
information that is available to you when formulating your optimal forecast.
Predicting Stock Prices: A forecasting model
In the equation below, we could add a plethora of information that is available today.33
Naturally, we would want to use only the relevant information but how do we know what
33
In the conduct of monetary policy, the Fed monitors over 850,000 data series.
53
information is relevant and what information is not? In the equation below, ie stands for
expected interest rates, UR for unemployment rates, CC for consumer confidence, GDP
for gross domestic product, HS for housing starts, etc. Naturally, we could just keep on
adding variables to the model and thus, the forecasting model will become very complex
(Ωt is extremely large). Thankfully, we have the efficient market theory to make ‘life’
much easier.


S t 1  f ite , UR, CC, GDP, HS , 
THE EFFICIENT MARKET THEORY
Definition: If markets are efficient, then the current asset price has already incorporated
all the relevant and available information related to that asset. Furthermore, if
markets are efficient, then NEWS, as defined as the ‘unexpected,’ is immediately
reflected in the asset price. That is, asset prices process new information very quickly
and accurately (as in the snowfall and commute to work example).
Implications of the efficient market theory – since efficient markets imply that the
current asset price has already incorporated all the relevant and currently available
information, then it would be a waste of our time (fruitless) building fancy and
complex models to predict future asset prices, since today’s price has already
processed all the current, relevant and available information. The good news is
that it makes our forecasting equation very simple. The bad news is that in order to
predict changes the stock price, we would need to predict the unexpected; e.g., we
would need a crystal ball.34 Good luck with that!
Best forecasting equation assuming efficient markets:
St+1 = f (St)
In other words, the best predictor of tomorrow’s stock price is today’s stock price.
This fact supports the Efficient Market Theory which states that today’s stock price
contains all current and relevant information associated with the fundamental value of
the firm that is available today (it efficiently processes what is in Ωt). According to
efficient markets, the only reason that tomorrow’s stock price will differ from today’s
would be due to NEWS that occurs between today and tomorrow. So, in effect, the
NEWS is exactly equal to FE, which is defined as the forecast error. If there is no
news then FE=zero, and St = St+1.35
34
We would actually need two crystal balls, one to predict the NEWS and another to predict the (asset
price) reaction to the NEWS.
35
This statement ignores what is often referred to as the ‘equilibrium return’ in the ‘market.’ We know that
the bond market and the stock market are often substitutes for investors’ funds and thus, investing in the
stock market embodies a positive expected return.
54
S t 1  S t  FE
FE is the Forecast Error
Properties of the forecast error, assuming efficient markets (recall commute to work ex.).
1. The FE must have a mean of zero (we assume that good news is as likely as
bad news).
2. The FE must be independent of Ωt, where Ωt is the entire information set
that is available at time t. If FE is not independent, that implies that St is not
processing all the relevant and available information contained in Ωt, and thus,
violates the assumption of the efficient market theory.
3. The FE must be uncorrelated with past FE’s (serially uncorrelated). Another
way to state this is that NEWs is completely absorbed immediately so that
today’s forecast error does not help us predict tomorrows forecast error.
Recall specifically the commute to work example when there was a 1)
accident that resulted in being late for work and 2) the road construction.
Even though these was a large forecast error (we were really late for work),
does that forecast error help us predict the forecast error tomorrow. The
answer is no, the expected forecast error would again be zero, since rational
expectations formation ensures that we use all relevant information available.
TESTING THE EFFICIENT MARKET THEORY (EMT)
My goal in what follows is to give you a clue as to what many economists do for a living,
and that is, crunch numbers! A good amount of economic research is theoretical, and a
good amount of economic research is empirical. I much prefer empirical analysis, and
empirical analysis is often utilized to test (prove or disprove) economic theories.36
A Primer on Regression Analysis: A Consumption Function Example
The example below should be a little familiar to you from econ 004. Consumption
accounts for about 70% of GDP and is thus, very much studied by economists and
other economic actors interested in understanding and predicting economic activity.
In econ 004 you should, at the very least, recall that disposable income and the level
of consumption are tightly related, that is, if we have data on disposable income, then
we can make pretty good guesses as to the level of consumption. You should also
recall that consumption is also influenced by other factors as well. In what follows,
we develop a fairly realistic model of consumption, and then we simplify it when
interpreting the empirical results.
Consumption Function
36
The proper jargon is thateconomists use econometrics to conduct empirical analysis. Keep in mind that
the results from empirical analyses are often contentious since the results are often sensitive to the
econometric techniques employed and/or the sample selection.
55





 

C  f  Yd , WSM , WRE , r , EX , CC 


where:
Yd is personal disposable income
WSM is wealth in the stock market
WRE is wealth in real estate
r is the real interest rate
EX is the exchange rate where an increase implies the dollar is
appreciating
CC is consumer confidence
If we used all the variables (above) to predict consumption, the regression
equation will take the following form:
C  a1Yd  a2WSM  a3WRE  a4 r  a5 EX  a6 CC
The ai’s are sensitivity parameters. They tell us which direction and by how much
consumption is affected by changes in each of the variables. For instance, a1 is the
marginal propensity to consume (MPC), and tells us how sensitive consumption is to
changes in disposable income.37
Empirical Results – The Consumption Function
The set up: I estimate a “mini” consumption function that includes two arguments:
disposable income and the real interest rate. The purpose of this example is to get you
familiar with the usefulness and interpretation of these empirical results.
Important features of regression output:
R2 represents the fit of the model; the higher the R2, the better the fit. The maximum
value for R2 is 1.00 and the minimum value is zero.
t-stats; if the absolute value of the t-stat exceeds 2.00, then we say that the associated
variable ‘belongs’ in the regression. t-stats basically test whether or not a coefficient is
significantly different than zero. If the t-stat exceeds two, then the coefficient is said to
be ‘statistically different than zero.’
Coefficient interpretation: We are typically interested in the sign of the coefficient (i.e.,
is it consistent with economic theory) as well as the size (this has to do with economic
37
You should recall the marginal propensity to consume from your principles classes and also that the
value of the MPC plays a critical role in determining the “multiplier” and thus, determining, in part, the
‘power’ of monetary and fiscal policy.
56
significance). Example: the MPC (a1) in the equation above should be positive, close to
one, and significant.38
Empirical Results on the mini consumption function
Equation estimated
C = a0 + a1 Yd + a2 r ff
Priors:
a1 is the marginal propensity to consume and should be somewhere around 0.9 in value.
a2 should be negative since the lower the real rate of interest, the less in pays to save (i.e.,
consume!).
The fit should be quite good, since we know that there is tight relationship between Yd
and C.
Results
Dependent Variable: Consumption
Method: Least Squares
Date: 10/13/05 Time: 12:15
Sample (adjusted): 1987M02 2005M08
Included observations: 223 after adjustments
Variable
Coefficient
Std. Error
t-Statistic
Prob.
ao
Yd
rff
1837.302
1.015550
-0.078855
457.6706
0.004001
0.016039
4.014465
253.8458
-4.916470
0.0001
0.0000
0.0000
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.998747
0.998735
58.01901
740565.2
-1220.465
1.061403
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
5481.939
1631.541
10.97278
11.01862
87666.56
0.000000
C = 1837 + 1.016 Yd + (- 0.07) r ff
38
Most believe that the MPC in the US is quite high relative to the rest of the world with the empirical
estimates somewhere around 0.9, which implies that for each $1.00 increase in disposable income,
consumption will rise by 90 cents with the remaining 10 cents being saved.
57
All variables are significant (see t-statistic), the fit is great (see R2), and the
coefficients are of the correct sign. Note that the MPC (a1) is very high, above 1!
What are the implications here? Can we make sense of this?
58
Testing of the efficient market hypothesis
Data: Closing price of Coke – daily data, 1970 – 1999.
The graph below depicts that data that will be used to test the efficient market
hypothesis.
160
140
120
100
80
60
40
20
1/02/70
9/02/77
5/03/85
1/01/93
CLOSE - Coke
As we know, according to the efficient market theory, the best predictor of tomorrow’s
(coke) stock price is today’s (coke) price.
Our regression model takes the following form:
St+1 = α0 + α1St
Priors: If the efficient market theory holds, we should 1) see a good fit (a high R2), 2)
an α1 near 1 and significant. We also need to obtain the forecast errors and examine
them to see if they embody the characteristics previously discussed: the FE must have
a mean of zero, be independent of Ωt where Ωt the entire information set that is
available at time t, and the FE must be uncorrelated with past FE’s (serially
uncorrelated).
59
Results:
Dependent Variable: Coke
Method: Least Squares
Date: 10/24/04 Time: 11:20
Sample(adjusted): 1/05/1970 1/25/1999
Included observations: 7581 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
Coke(-1)
0.113314
0.998174
0.047963
0.000689
2.362514
1449.142
0.0182
0.0000
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.996404
0.996403
1.673779
21232.84
-14660.82
2.008938
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
63.79229
27.90979
3.868308
3.870138
2100012.
0.000000
St+1 = 0.11 + 0.9981St
R2 = 0.996
So the results are consistent with our priors. The fit is terrific with the R2 approaching
one and the coefficient on today’s coke price (α1) also approaching one.
60
Tests on the forecast errors:
Test 1: Mean of zero?
The chart below depicts some statistics on the forecast error. According efficient
markets, the forecast error should have a mean of zero. As you can see from the results,
the forecast error has a mean very close to zero.
5000
Series: Close (t) - Close (t-1)
Sample 1/05/1970 1/25/1999
Observations 7581
4000
3000
2000
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
-0.003166
0.000000
6.000000
-82.75000
1.674444
-23.14830
962.4173
Jarque-Bera
Probability
2.91E+08
0.000000
1000
0
-75.0 -62.5 -50.0 -37.5 -25.0 -12.5 0.0
61
Test 2: Independent of Ωt ?
To conduct this test correctly, we would need to include virtually and infinite amount of
variables on the right hand side of the equation (all the information, relevant or not) that
were available at time t. Since this is unreasonable, I have decided to include the current
and past values of coke to see if they can possibly predict tomorrow’s forecast error.
Priors: the ‘Fit’ as measured by R2 should be very poor and all the coefficients should be
insignificantly different from zero.
Results:
Dependent Variable: Forecast Errors
Method: Least Squares
Date: 03/14/05 Time: 14:08
Sample (adjusted): 1/09/1970 1/25/1999
Included observations: 7577 after adjustments
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
CLOSE(t)
CLOSE(t-1)
CLOSE(t-2)
CLOSE(t-3)
CLOSE(t-4)
-0.002946
-0.004620
-0.002241
-0.006108
0.011725
0.001287
0.048054
0.011493
0.016200
0.016200
0.016200
0.011492
-0.061314
-0.401970
-0.138322
-0.377004
0.723806
0.112013
0.9511
0.6877
0.8900
0.7062
0.4692
0.9108
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.000237
-0.000423
1.674370
21225.40
-14653.76
2.000054
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
-3.49E-05
1.674016
3.869542
3.875032
0.359482
0.876388
As we can see from the regression results, trying to predict tomorrow’s forecast error
with information available today is fruitless, consistent with the efficient market theory.
The R2 is extremely low (.000237) suggesting a very poor fit of this model. None of the
lagged closing prices of Coke are significant, implying that they contain no useful
information in predicting the forecast error.
62
Test 3: The forecast errors are serially uncorrelated (past forecast errors do not
help predict future forecast errors).
Priors: Fit should be poor (as measured by the R2) and all the coefficients should be
insignificantly different than zero.
Results:
Dependent Variable: FE(t+1)
Method: Least Squares
Date: 10/25/04 Time: 11:11
Sample(adjusted): 1/19/1970 1/25/1999
Included observations: 7571 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
FE(t)
FE(t-1))
FE(t-2)
FE(t-3)
FE(t-4)
FE(t-5)
FE(t-6)
FE(t-7)
FE(t-8)
FE(t-9)
-0.003859
-0.005667
-0.008836
-0.014633
-0.002607
-0.026925
0.004066
-0.019810
-0.004913
-0.003631
-0.021146
0.019250
0.011499
0.011499
0.011499
0.011498
0.011497
0.011498
0.011498
0.011499
0.011498
0.011498
-0.200447
-0.492847
-0.768422
-1.272572
-0.226782
-2.341823
0.353615
-1.723006
-0.427293
-0.315763
-1.839080
0.8411
0.6221
0.4423
0.2032
0.8206
0.0192
0.7236
0.0849
0.6692
0.7522
0.0659
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.001850
0.000529
1.674927
21208.67
-14642.17
2.000118
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
-0.003533
1.675370
3.870868
3.880940
1.401002
0.172788
The results above are also consistent with the properties of the FE according to the
efficient market theory as the model fits the data very poorly (R2 = 0.001850).
Summary: Our empirical results are consistent with the efficient market theory implying
that it is impossible to predict changes in stock prices, suggesting that the closing price
of coke follows a random walk.39
Another way to state this is that it is impossible to “beat the market.”
The Wall Street Journal tested this random walk proposition by comparing the return of
professional investors against a portfolio that was chosen by throwing darts. For more
information, see:
A very well known book regarding this topic is titled “A Random Walk Down Wall Street,” and is
authored by Burton G. Malkiel.
39
63
Journal's Dartboard Retires
After 14 Years of Stock Picks
By GEORGETTE JASEN
Staff Reporter of THE WALL STREET JOURNAL
Below is a graphic summarizing the results:
Most economists believe that all three of the asset markets; stocks, bonds, and foreign
exchange are quite efficient. The article below contains a discussion among two very
prominent economists from the University of Chicago.
64
October 18, 2004
PAGE ONE
Stock Characters
As Two Economists
Debate Markets,
The Tide Shifts
Belief in Efficient Valuation
Yields Ground to Role
Of Irrational Investors
Mr. Thaler Takes On Mr. Fama
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL
October 18, 2004; Page A1
For forty years, economist Eugene Fama argued that financial
markets were highly efficient in reflecting the underlying value of
stocks. His long-time intellectual nemesis, Richard Thaler, a
member of the "behaviorist" school of economic thought,
contended that markets can veer off course when individuals make
stupid decisions.
In May, 116 eminent economists and business executives gathered
at the University of Chicago Graduate School of Business for a
conference in Mr. Fama's honor. There, Mr. Fama surprised some
in the audience. A paper he presented, co-authored with a
colleague, made the case that poorly informed investors could
theoretically lead the market astray. Stock prices, the paper said,
could become "somewhat irrational."
Coming from the 65-year-old Mr. Fama, the intellectual father of the theory known as the
"efficient-market hypothesis," it struck some as an unexpected concession. For years,
65
efficient market theories were dominant, but here was a suggestion that the behaviorists'
ideas had become mainstream.
"I guess we're all behaviorists now," Mr. Thaler, 59, recalls saying after he heard Mr.
Fama's presentation.
Roger Ibbotson, a Yale University professor and founder of Ibbotson Associates Inc., an
investment advisory firm, says his reaction was that Mr. Fama had "changed his thinking
on the subject" and adds: "There is a shift that is taking place. People are recognizing that
markets are less efficient than we thought." Mr. Fama says he has been consistent.
The shift in this long-running argument has big implications for real-life problems,
ranging from the privatization of Social Security to the regulation of financial markets to
the way corporate boards are run. Mr. Fama's ideas helped foster the
free-market theories of the 1980s and spawned the $1 trillion indexfund industry. Mr. Thaler's theory suggests policy makers have an
important role to play in guiding markets and individuals where
they're prone to fail.
Take, for example, the debate about Social Security. Amid a tight
election battle, President Bush has set a goal of partially privatizing
Social Security by allowing younger workers to put some of their
payroll taxes into private savings accounts for their retirements.
In a study of Sweden's efforts to privatize its retirement system, Mr.
Thaler found that Swedish investors tended to pile into risky
technology stocks and invested too heavily in domestic stocks. Investors had too many
options, which limited their ability to make good decisions, Mr. Thaler concluded. He
thinks U.S. reform, if it happens, should be less flexible. "If you give people 456 mutual
funds to choose from, they're not going to make great choices," he says.
If markets are sometimes inefficient, and stock prices a flawed measure of value,
corporate boards and management teams would have to rethink the way they compensate
executives and judge their performance. Michael Jensen, a retired Harvard economist
who worked on efficient-market theory earlier in his career, notes a big lesson from the
1990s was that overpriced stocks could lead executives into bad decisions, such as
massive overinvestment in telecommunications during the technology boom.
Even in an efficient market, bad investments occur. But in an inefficient market where
prices can be driven way out of whack, the problem is acute. The solution, Mr. Jensen
says, is "a major shift in the belief systems" of corporate boards and changes in
compensation that would make executives less focused on stock price movements.
Few think the swing toward the behaviorist camp will reverse the global emphasis on
open economies and free markets, despite the increasing academic focus on market
66
breakdowns. Moreover, while Mr. Fama seems to have softened his thinking over time,
he says his essential views haven't changed.
A product of Milton Friedman's Chicago School of thought, which stresses the virtues of
unfettered markets, Mr. Fama rose to prominence at the University of Chicago's Graduate
School of Business. He's an avid tennis player, known for his disciplined style of play.
Mr. Thaler, a Chicago professor whose office is on the same floor as Mr. Fama's, also
plays tennis but takes riskier shots that sometimes land him in trouble. The two men have
stakes in investment funds that run according to their rival economic theories.
Highbrow Insults
Neither shies from tossing about highbrow insults. Mr. Fama says behavioral economists
like Mr. Thaler "haven't really established anything" in more than 20 years of research.
Mr. Thaler says Mr. Fama "is the only guy on earth who doesn't think there was a bubble
in Nasdaq in 2000."
In its purest form, efficient-market theory holds that markets distill new information with
lightning speed and provide the best possible estimate of the underlying value of listed
companies. As a result, trying to beat the market, even in the long term, is an exercise in
futility because it adjusts so quickly to new information.
Behavioral economists argue that markets are imperfect because people often stray from
rational decisions. They believe this behavior creates market breakdowns and also buying
opportunities for savvy investors. Mr. Thaler, for example, says stocks can under-react to
good news because investors are wedded to old views about struggling companies.
For Messrs. Thaler and Fama, this is more than just an academic debate. Mr. Fama's
research helped to spawn the idea of passive money management and index funds. He's a
director at Dimensional Fund Advisers, a private investment management company with
$56 billion in assets under management. Assuming the market can't be beaten, it invests
in broad areas rather than picking individual stocks. Average annual returns over the past
decade for its biggest fund -- one that invests in small, undervalued stocks -- have been
about 16%, four percentage points better than the S&P 500, according to Morningstar
Inc., a mutual-fund research company.
Mr. Thaler, meanwhile, is a principal at Fuller & Thaler, a fund management company
with $2.4 billion under management. Its asset managers spend their time trying to pick
stocks and outfox the market. The company's main growth fund, which invests in stocks
that are expected to produce strong earnings growth, has delivered average annual returns
of 6% since its inception in 1997, three percentage points better than the S&P 500.
Mr. Fama came to his views as an undergraduate student in the late 1950s at Tufts
University when a professor hired him to work on a market-forecasting newsletter. There,
he discovered that strategies designed to beat the market didn't work well in practice. By
the time he enrolled at Chicago in 1960, economists were viewing individuals as rational,
67
calculating machines whose behavior could be predicted with mathematical models.
Markets distilled these differing views with unique precision, they argued.
"In an efficient market at any point in time the actual price of a security will be a good
estimate of its intrinsic value," Mr. Fama wrote in a 1965 paper titled "Random Walks in
Stock Market Prices." Stock movements were like "random walks" because investors
could never predict what new information might arise to change a stock's price. In 1973,
Princeton economist Burton Malkiel published a popularized discussion of the
hypothesis, "A Random Walk Down Wall Street," which sold more than one million
copies.
Mr. Fama's writings underpinned the Chicago School's faith in the functioning of
markets. Its approach, which opposed government intervention in markets, helped
reshape the 1980s and 1990s by encouraging policy makers to open their economies to
market forces. Ronald Reagan and Margaret Thatcher ushered in an era of deregulation
and later Bill Clinton declared an end to big government. After the collapse of
Communist central planning in Russia and Eastern Europe, many countries embraced
these ideas.
As a young assistant professor in Rochester in the mid-1970s, Mr. Thaler had his doubts
about market efficiency. People, he suspected, were not nearly as rational as economists
assumed.
Mr. Thaler started collecting evidence to demonstrate his point, which he published in a
series of papers. One associate kept playing tennis even though he had a bad elbow
because he didn't want to waste $300 on tennis club fees. Another wouldn't part with an
expensive bottle of wine even though he wasn't an avid drinker. Mr. Thaler says he
caught economists bingeing on cashews in his office and asking for the nuts to be taken
away because they couldn't control their own appetites.
Mr. Thaler decided that people had systematic biases that weren't rational, such as a lack
of self-control. Most economists dismissed his writings as a collection of quirky
anecdotes, so Mr. Thaler decided the best approach was to debunk the most efficient
market of them all -- the stock market.
Small Anomalies
Even before the late 1990s, Mr. Thaler and a growing legion of behavioral finance
experts were finding small anomalies that seemed to fly in the face of efficient-market
theory. For example, researchers found that value stocks, companies that appear
undervalued relative to their profits or assets, tended to outperform growth stocks, ones
that are perceived as likely to increase profits rapidly. If the market was efficient and
impossible to beat, why would one asset class outperform another? (Mr. Fama says
there's a rational explanation: Value stocks come with hidden risks and investors are
rewarded for those risks with higher returns.)
68
Moreover, in a rational world, share prices should move only when new information hit
the market. But with more than one billion shares a day changing hands on the New York
Stock Exchange, the market appears overrun with traders making bets all the time.
Robert Shiller, a Yale University economist, has long argued that efficient-market
theorists made one huge mistake: Just because markets are unpredictable doesn't mean
they are efficient. The leap in logic, he wrote in the 1980s, was one of "the most
remarkable errors in the history of economic thought." Mr. Fama says behavioral
economists made the same mistake in reverse: The fact that some individuals might be
irrational doesn't mean the market is inefficient.
Shortly after the stock market swooned, Mr. Thaler presented a new paper at the
University of Chicago's business school. Shares of handheld-device maker Palm Inc. -which later split into two separate companies -- soared after some of its shares were sold
in an initial public offering by its parent, 3Com Corp., in 2000, he noted. The market
gave Palm a value nearly twice that of its parent even though 3Com still owned 94% of
Palm. That in effect assigned a negative value to 3Com's other assets. Mr. Thaler titled
the paper, "Can the Market Add and Subtract?" It was an unsubtle shot across Mr. Fama's
bow. Mr. Fama dismissed Mr. Thaler's paper, suggesting it was just an isolated anomaly.
"Is this the tip of an iceberg, or the whole iceberg?" he asked Mr. Thaler in an open
discussion after the presentation, both men recall.
Mr. Thaler's views have seeped into the mainstream through the support of a number of
prominent economists who have devised similar theories about how markets operate. In
2001, the American Economics Association awarded its highest honor for young
economists -- the John Bates Clark Medal -- to an economist named Matthew Rabin who
devised mathematical models for behavioral theories. In 2002, Daniel Kahneman won a
Nobel Prize for pioneering research in the field of behavioral economics. Even Federal
Reserve Chairman Alan Greenspan, a firm believer in the benefits of free markets,
famously adopted the term "irrational exuberance" in 1996.
Andrew Lo, an economist at the Massachusetts Institute of Technology's Sloan School of
Management, says efficient-market theory was the norm when he was a doctoral student
at Harvard and MIT in the 1980s. "It was drilled into us that markets are efficient. It took
me five to 10 years to change my views." In 1999, he wrote a book titled, "A NonRandom Walk Down Wall Street."
In 1991, Mr. Fama's theories seemed to soften. In a paper called "Efficient Capital
Markets: II," he said that market efficiency in its most extreme form -- the idea that
markets reflect all available information so that not even corporate insiders can beat it -was "surely false." Mr. Fama's more recent paper also tips its hand to what behavioral
economists have been arguing for years -- that poorly informed investors could distort
stock prices.
But Mr. Fama says his views haven't changed. He says he's never believed in the pure
form of the efficient-market theory. As for the recent paper, co-authored with longtime
69
collaborator Kenneth French, it "just provides a framework" for thinking about some of
the issues raised by behaviorists, he says in an e-mail. "It takes no stance on the empirical
importance of these issues."
The 1990s Internet investment craze, Mr. Fama argues, wouldn't have looked so crazy if
it had produced just one or two blockbuster companies, which he says was a reasonable
expectation at the time. Moreover, he says, market crashes confirm a central tenet of
efficient market theory -- that stock-price movements are unpredictable. Findings of other
less significant anomalies, he says, have grown out of "shoddy" research.
Defending efficient markets has gotten harder, but it's probably too soon for Mr. Thaler
to declare victory. He concedes that most of his retirement assets are held in index funds,
the very industry that Mr. Fama's research helped to launch. And despite his research on
market inefficiencies, he also concedes that "it is not easy to beat the market, and most
people don't."
Write to Jon E. Hilsenrath at jon.hilsenrath@wsj.com1
URL for this article:
http://online.wsj.com/article/0,,SB109804865418747444,00.html
Hyperlinks in this Article:
(1) mailto:jon.hilsenrath@wsj.com
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70
Using technical analysis – Although there are many, these Bollinger Bands examples
will give us a good feel for this notion of technical analysis. Note that technical
analysis is completely removed from the fundamentals, which are based on expected
profits and interest rates. As such, “technical analysts” are often referred to as
“chart watchers,” as the following, as the following analysis demonstrates.
Bollinger bands are a very useful and popular technique in predicting stock
movements. They provide many useful signals, such as whether a price is relatively high
or low, whether a current trend is likely to continue or reverse, and market volatility.
What separates Bollinger bands from most other price channeling techniques is in the
way the bands are derived. Rather than setting the channels at a fixed percentage above
and below the moving average, Bollinger bands are plotted two standard deviations
above and below the moving average. This is done to ensure that 95% of price data will
fall between the bands. It also ensures that the bands are sensitive to volatility.
When speaking of market trends, Bollinger bands can provide a signal based on
both penetrations of the bands, as well as width of the bands. A penetration of either
band, high or low, implies a continuation of the current trend. When the bands move far
apart relative to the norm, the current trend may be ending. If the bands are unusually
tight, it may be a sign of a new trend beginning.
Price targets can also be achieved through the use of Bollinger bands. For
example, if a price is moving along the lower band and proceeds to cross above the
moving average, the upper band will become a price target. Of course, the opposite also
applies.
Finally, momentum can also be checked through the use of Bollinger bands. If a
price is seen to move above or below a band, and on a subsequent move, fails to reach the
band for a second time, there is a good chance that momentum is being lost and a reversal
may be in the works. It is important to note that even if the subsequent move reaches a
higher or lower price, it must still penetrate the respective band in order to indicate
lasting momentum.
Bollinger Bands – Test One
71
Above we see a current six-month chart of Dell Inc. (DELL) The standard set up
for use of Bollinger bands includes a six-month chart, along with a 20-day moving
average. Starting from the left portion of the graph, you can see the sell signals, indicated
by red arrows. As you can see, as the price bars (blue) pass through the bottom band
during mid-March, a trend may be starting. In addition, the bands are fairly tight during
this time period. As we progress into the early and middle of April, the lower band
continues to be penetrated by the price, confirming the downtrend. As the bands widen
into May, the price begins to stabilize and then rise. Dell’s price then crosses through the
moving average and continues up through the upper band. However, it does not continue
to hug the band, so no uptrend can be confirmed. As the bands become very wide through
late May and early June, the price evens out. Two more potential buy signals are seen in
June and July, but once again, only for a couple of days at a time. During this time,
attention should also be focused on the bands, which are once again becoming tighter.
Looking back on what was just covered; it is safe to say that the rules regarding
Bollinger bands seem to work just as described. For each change in price, the bands
properly adjusted and did not provide any erratic signals. That being said, the buy and
sell signals shown on the graph should not be immediately followed as soon as a band is
penetrated. While each instance would provide a profit if followed, most would be
minimal.
Using the rules provided by Bollinger bands, it would seem quite easy to predict
the short-term future for Dell’s stock price. However, there are no definitive movements
currently in progress. We can still take a look at what the chart is showing us and try to
make an educated guess. The bands are beginning to widen once again, implying less
volatility. The price has recently dropped below the moving average and seems to be
staying somewhat near the lower band. The price drop does not appear to look
dramatically sharp, and looking at similar trends and price levels throughout the past six
months, it seems as though there will be no drastic price changes in the near future. But,
if the price continues to descend throughout the following week and eventually hugs the
bottom band, there is a good chance we may be seeing the start of a downtrend worth
moving in on with a short-position.
Bollinger Bands – Test Two
To get a better view of the accuracy and potential gains associated with Bollinger
bands, let’s take a look at some more examples and see how they fare. The chart below
depicts the current state of Ford Motor Company’s (F) stock. It provides a good look at a
consistent downtrend beginning in late February through mid-April. Taking a short
position at first sign of a downtrend on February 25 at a price of 13.00 and riding it out
through April 22 at 9.89 would provide a change of 23.92%. Comparing this change to
the S&P 500 rate of 4.89%, we can undoubtedly say that we would have beaten the
market. Also interesting to point out is the single buy signal, which if followed would
provide a false signal, and thus a loss.
72
Bollinger Bands – Test Three
The next chart shows the previous six months of International Business Machines
(IBM) stock and a good opportunity to profit from both the drop and rise in price during
this time. If a short position was taken at the first sell signal on March 22 at a price of
89.50 and held onto until it was clear that the trend was over on, say, April 26 at 74.65,
then it would clearly show a market beating opportunity (-16.59% change). During the
same time period, the S&P 500 was growing at a rate of -1.70%, so it is clear that
following the bands would have paid off.
In the second part, taking a long position at the sign of an uptrend starting July 11
at a price of 78.96 and selling off on July 22 (84.44) once it appears the trend is over,
another profitable opportunity is seen. A change of 6.94% is seen, as compared to the
S&P 500 of 1.17%.
Bollinger bands can provide information about the market that many other
technical strategies cannot. When seeking information regarding volatility, the bands are
second to none. Furthermore, once locked into a trend, Bollinger bands can give us a very
73
good idea of what to expect in the near future. One needs to use caution when studying
Bollinger bands however, as prices movements which penetrate the outer bands do not
always send the correct signal. Instead, it is the movement that occurs near the outer
bands that is most important, especially when the movements are consistent. That is
where the real strength of Bollinger bands shines through.
74
Key Terms
1. Stock price determination formula.
2. The efficient market theory.
3. Autoregressive properties.
4. Technical analysis.
5. Jawboning.
6. Price to earnings ratio.
7. Earnings per share.
8. Inside information.
9. Random walk.
10. Two Crystal Balls
11. Bollinger bands
75
Chapter 3: The Money Market and the Federal Reserve
Our objective is to understand both sides of the money market – money supply
where the Fed plays a major role and money demand.
We begin with a world with two assets – money and bonds. More generally, we
want to define money as a non-interest bearing asset that is used for transactions
(transactions money). Bonds on the other hand are less liquid, interest bearing, and
cannot be used directly for transactional purposes. Jumping forward, these points are
important in determining money demand – for example, if interest rates are very high,
then you will hold more bonds since it is so costly to hold money. Naturally, low interest
rates mean that the costs of holding money are low so you tend to hold more money
(think of Japan). These are important issues in terms of money demand – but we will do
money supply first.
Money Supply
When we think of money supply, we think of the Fed: Doesn’t the Fed control
the money supply?? Sort of – let’s be precise and say that the Fed has a lot of influence
over the money supply – in particular, M1, which is the monetary aggregate that includes
the most liquid assets: Cash (Currency) and Demand Deposits (Checking accounts). M1
also includes travelers’ checks but these are so small in proportion – we’ll just assume
them away! There are many other monetary aggregates like M2, M3, LM3, etc. M2 is
simply broader than M1 in that M2 includes M1 plus other, less liquid assets like small
time savings accounts including CDs. FYI, the Federal Reserve in the late 1970s and
early 1980s used to target M1 since they felt that there was a close connection between
M1 and their ultimate objectives. In the early 1980s, this relationship broke down so the
Fed targeted M2. This relationship broke down as well and the Fed threw up their hands
and follow an eclectic or ‘informational variable’ approach; looking at a variety of
variables in hopes of determining the direction of the economy (boiler example) –
remember – the Fed most definitely needs to be forward looking.
Back to M1 – for ease of notation we’ll just use M
The purpose of the few equations below is for you to understand that the Fed has
imperfect control of the money supply due to changes in household and bank behavior
that influences the money multiplier and in turn, influences the money supply. We will
use the great depression as an example to drive home this point. We will also mention
Y2K in this context.
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Money Supply
Define money as above:
1) M = C + D where C = currency (cash) and D = demand deposits (checking accounts)
The Fed has pretty darn good control over what is referred to as the monetary base (MB)
(also referred to as high powered money since changes in MB due to open market
operations result in high powered effects, via the money multiplier, on the money
supply). Define MB as follows with C = currency as before, TR equals total reserves, a
combination of required reserves (RR) and excess reserves (ER).
2) MB = C + TR
Divide 1) by 2)
3) M/MB = (C + D)/(C + TR)
Now a trick – divide the numerator and denominator of the RHS (right hand side) of 3)
by D
4) M/MB = (C /D+ D/D)/(C/D + TR/D)
Let’s do a few things to 4) – a) get MB on RHS, b) D/D = 1, and c) TR = RR + ER
5) M = [(C /D+ 1)/(C/D + RR/D + ER/D)] MB
The term in brackets is referred to as the money multiplier, which is a little different
than what you saw in principles. Equation 5) implies that the money multiplier is
influenced by household behavior via C/D, which is determined by us. C/D is simply the
currency to deposit ratio. For example, if you typically carry $100 in cash and you have
$1000 in a demand deposit, then your C/D is 0.1. Think about what happened to C/D
during Y2K.
Equation 5) also implies that bank behavior influences the money multiplier via
ER/D. Even though banks tend to get rid of excess reserves (ER) since they earn no
interest, sometimes they hold on to them. What do you think banks were doing during
Y2K? Probably holding a lot of ER to meet the liquidity needs of their customers (they
anticipated significant withdrawals)!
The last player that has influence over the money multiplier is the Fed themself
via RR/D which is simply the reserve requirement ratio (this is what you were supposed
to learn in principles).
Specifics on the money multiplier. If C/D, ER/D, or RR/D go up, then the
multiplier falls. This is important, because if MB remains constant, the money supply
77
will fall. We will now use an example that is a simplified version of what happened
during the great depression.
Some numbers – let C/D = .2 , RR/D = .1 and ER/D = 0
Multiplier = (.2 +1)/ (.2 + .1 + 0) = 4
What does this mean?
A couple things – suppose the MB is $ 100 billion ; M = $ 400 billion
A 10 billion dollar open market purchase will result in a $40 billion increase in the
money supply (remember high powered money!) See the two graphs below
Rs
Rs’
i
i
100
110
Ms
Ms’
400
440
R (MB)
M
78
Question: In the top diagram, the reserve market, what is the interest rate that belongs on
the vertical axis? What about the bottom diagram??
The Great Depression – an Example
The Fed is blamed by some for causing the great depression or at least failing to respond
appropriately.
What will a bank run do to C/D ratios?
So C/D rose dramatically as people were trying to get their cash – remember, no FDIC
insurance back then.
ER/D also rose for two reasons – one, banks were keeping ER to meet the liquidity needs
of their customers and two, had no one to lend to – banks are reluctant to make loans in
such a dismal environment.
Ironically, RR/D went up as well. The Fed was young, less than 20 years in existence
and felt that raising the required reserve ratio would make banks more sound as well as
giving the public more confidence so that they would not run on banks – in hindsight,
raising the required reserve ratio was a mistake!
All three components of money multiplier rose during the great depression – impact on
money multiplier?
Recall Money Multiplier equals:
[(C /D+ 1)/(C/D + RR/D + ER/D)]
Initially, let C/D = .2 , RR/D = .1 , and ER/D = 0
With numbers:
[(.2+ 1)/(.2 + .1 + 0)] = 4
Now account for changes in C/D, RR/D, ER/D
Let C/D up to .5, RR/D up to .2, ER/D up to .3
[(.5+ 1)/(.5 + .2 + .3] = 1.5
NEW Multiplier = 1.5
With numbers – before the great depression
M = ( 4 ) MB
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If MB = $ 100 billion ; M = $ 400 billion
Now great depression hits and the multiplier falls to 1.5
MB still at $100 billion – M = 150 billion
Now the Fed isn’t blind – they buy $ 100 billion in Gov Securities, increasing MB by
$100 billion – Money Supply up to $300 billion (1.5 times $200 billion) – still a 25%
drop from where it was initially.
So the Fed pumped up the Monetary Base via open market purchases – but it was not
enough to offset the dramatic fall in the money multiplier – they should have been
easier!!
The lesson here is that the Fed has incomplete control over the money supply and in order
to have better control, they better try to figure out what determines C/D and ER/D ratios.
In normal times, these are pretty stable so that ‘normally,’ the Fed has pretty good control
over the money supply (M1).
In terms of graphs – in the reserve market, reserve supply doubled to $200 billion but in
the money market, Ms shifted to the left!
A few comments:
We have FDIC insurance now so bank runs are unlikely. The closest thing to a bank run
was the environment during Y2K. People didn’t trust computers and grabbed cash
instead. This was foreseeable, so the Fed, to offset the fall in the multiplier, should buy
lots of bonds thereby injecting lots of reserves into the system. Did they? Not exactly –
they used the discount window instead. They essentially told banks that you could
borrow all you need from us, the Fed, without worrying about the standard implicit cost
from borrowing from the Fed. Normally, banks are unwilling to borrow from the Fed
since borrowing from the Fed sends up a ‘red flag’ and increases the probability of being
audited by the Fed, something a bank certainly avoids. As a result, banks normally
would rather borrow off of other banks via the federal funds market. But during Y2k
they accepted the Feds offer and Y2k was not a problem!
The three tools of the Fed
Open Market operations – the buying and selling of government securities, Changes in
the Reserve Requirement Ratio – Changes in the discount rate.
The Fed conducts open market operations every business day – they guess where reserve
demand is and supply the necessary reserves in hopes of hitting their Federal Funds Rates
target! Sometimes they are wrong – recall this picture? When the federal funds rate is
high, then the Fed underestimated reserve demand – that is, reserve demand was larger
than they thought it would be. Conversely, if the federal funds rate is low, they
80
overestimated reserve demand. The Fed guesses what reserve demand will be every
business day, and conducts the appropriate amount of open market operations in hopes of
hitting the FF target as set by the FOMC.
Federal Funds Rate
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
J F MA MJ J A S O N D J F MA MJ J A S O N D J
1997
1998
Summary
The Fed tries to hit the target for the Federal Funds rate every business day by
conducting open market operations – the buying and selling of Government Securities.
This target is in accordance with the Fed’s ultimate objectives (remember those!).
The Fed does not have complete control over the money supply but they do have a lot of
influence.
81
A relatively recent and definitely a major change in the Fed’s discount rate policy:
The Discount Rate and Discount Rate Policy – The following articles explain what the
discount window is and how the policy regarding the discount window has changed. Be
sure to understand exactly what the change implies for the upper (intra-day) limit of the
federal funds rate.
May 17, 2002
ECONOMY
Fed Proposes a Big Change
In Its Emergency Lending
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- The Federal Reserve, trying to make its management of interest rates more
effective, is overhauling the way it makes loans to commercial banks through its discount
window.
The changes won't affect the stance of monetary policy. Under the proposed changes, the
discount rate would be significantly higher than it is now but discount window credit would be
granted with far less stringent conditions. This is meant to reduce the stigma and administrative
burden of using the discount window, thus increasing its use.
The discount window used to be an important supplement to open-market operations: It was a
way for the Fed to supply cash to banks and thus maintain its control over interest rates. But it
has fallen into disuse, as banks have become better at managing their cash needs. Furthermore,
because the Fed requires a bank to exhaust alternative sources of funds before granting the bank
discount window credit, banks avoid the discount window for fear of suggesting to the market
that they are in distress.
When the Sept. 11 terrorist attacks disrupted banks' access to the money markets, the Fed
publicly announced the discount window was available in part to remove that stigma. That
week, discount window loans topped $45 billion, a record. They typically fluctuate between $25
million and $300 million.
"There is an alleged stigma to the discount window and we intend to get rid of that," said Fed
Governor Edward Gramlich.
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By boosting use of direct loans to commercial banks, Fed
officials hope they will prevent volatility in the important
federal-funds rate due to temporary shortages of funds. The
federal funds rate is the rate commercial banks charge on
overnight loans to each other. Fed officials also hope to head
off any loss of control over interest rates resulting from
ongoing changes in the bank industry.
The discount rate is now 1.25%, a half-percentage point
beneath the 1.75% federal-funds rate target. Under the
proposal, on which the Fed is seeking comment, the discount
rate would be initially set a full percentage point above the
funds rate target, but that spread could then vary. The Fed
would be able to cut the discount rate quickly in an
emergency.
Furthermore, "primary" discount window credit would be granted to sound banks with few
questions asked and without requiring a bank to first exhaust alternatives. By setting the
discount rate above the funds rate, banks will be discouraged from using it as a routine funding
source. Troubled banks will be eligible for more restrictive "secondary" credit at a discount rate
charged half a percentage point above the primary discount rate.
But when the funds rate spikes above the Fed's intended target, banks are expected to turn to the
discount window -- relieving the pressure on market rates. Such spikes were common in the
early 1990s as hard-pressed banks sought ready cash but avoided the discount window. Today
spikes are more often the result of temporary funding pressures, such as when banks are
dressing up their balance sheets at quarter-end.
But the Fed also wants to prevent interest-rate volatility from rising because of changes in the
bank industry. Banks are required to hold a portion of their deposits on reserve at the Fed, and
the central bank manages interest rates by increasing or decreasing such reserves through open
market operations. In recent years, required reserves have been dropping as money-market
"sweep" accounts, which have no reserve requirements, spread. That trend could eventually
make it harder for the Fed to target interest rates precisely. The new discount-window system
could prevent that from happening.
Write to Greg Ip at greg.ip@wsj.com2
Updated May 17, 2002 8:53 p.m. EDT
Copyright 2002 Dow Jones & Company, Inc. All Rights Reserved
Printing, distribution, and use of this material is governed by your Subscription
agreement and Copyright laws.
For information about subscribing go to http://www.wsj.com
83
From Url: http://www.frbsf.org/education/activities/drecon/2004/0409.html
Ask Dr. Econ
I find definitions of the federal funds rate stating that it can be both
above and below the discount rate. Which is correct? (September 2004)
Great question! The correct answer depends on the time period. Since January
2003, when the Federal Reserve System implemented a “penalty” discount rate
policy, the discount rate has been about 1 percentage point, or 100 basis points,
above the effective (market) federal funds rate. The fed funds rate is the interest
rate that depository institutions—banks, savings and loans, and credit unions—
charge each other for overnight loans. The discount rate is the interest rate that
Federal Reserve Banks charge when they make collateralized loans—usually
overnight—to depository institutions.
The federal funds market
The fed funds rate and the discount rate are two of the tools the Federal Reserve
uses to set U.S. monetary policy. Let’s start by describing the more important of
these two short-term interest rates—the fed funds rate.
First, you should know that depository institutions are required by the Federal
Reserve to keep a certain amount of their deposits as required reserves, in the
form of vault cash or as electronic funds in reserve accounts with the Fed.1 Over
the course of each day, as banks pay out and receive funds, they may end up
with more (or fewer) funds than they need to meet their reserve requirement
target. Banks with excess funds typically lend them overnight to other banks that
are short on funds, rather than leaving those funds in their non-interest bearing
reserve accounts at the Fed or as idle vault cash.
This interbank market is known as the federal funds market and the effective
interest rate on daily transactions in this market is known as the federal funds
rate. As of September 2004, U.S. commercial banks reported about $360 billion
in daily average interbank loans, mostly federal funds loans—so you can see this
is a very important market for banks to make short-term adjustments to their
funding.
The Federal Reserve Bank of San Francisco publication, U.S. Monetary Policy:
An Introduction describes how the fed funds market works:
The interest rate on the overnight borrowing of reserves is called the federal
funds rate or simply the "funds rate." It adjusts to balance the supply of and
demand for reserves. For example, if the supply of reserves in the fed funds
market is greater than the demand, then the funds rate falls, and if the supply of
reserves is less than the demand, the funds rate rises.
84
Monetary policy and the fed funds rate
For monetary policy purposes, the Federal Reserve sets a target for the federal
funds rate and maintains that target interest rate by buying and selling U.S.
Treasury securities. When the Fed buys securities, bank reserves rise, and the
fed funds rate tends to fall. When the Fed sells securities, bank reserves fall, and
the fed funds rate tends to rise. Buying and selling securities, or open market
operations, is the Fed’s primary tool for implementing monetary policy.
Borrowing from the Fed’s Discount Window
Additionally, banks may borrow funds directly from the discount window at their
District Federal Reserve Bank to meet their reserve requirements. The discount
rate is the interest rate that banks pay on this type of collateralized loan. On a
daily average basis in September 2004, borrowing at the discount window
averaged only $335 million a day, a tiny fraction of the $360 billion daily
average for interbank loans during that month.
The following quote from the U.S. Monetary Policy: An Introduction, describes
how the discount window works and the discount rate is set:
The Boards of Directors of the Reserve Banks set these rates, subject to the
review and determination of the Federal Reserve Board… Since January 2003,
the discount rate has been set 100 basis points above the funds rate target,
though the difference between the two rates could vary in principle. Setting the
discount rate higher than the funds rate is designed to keep banks from turning to
this source before they have exhausted other less expensive alternatives. At the
same time, the (relatively) easy availability of reserves at this rate effectively
places a ceiling on the funds rate.
Historical comparison: Which rate was higher?
Historically the federal funds rate has been both above and below the discount
rate, although until 2003 the funds rate typically was above the discount rate.
Until January 2003, it was possible for the effective fed funds rate to fall below
the discount rate on occasion; however, normally the funds rate exceeded the
discount rate. This relationship can be seen in the Chart 1, which plots both the
interest rates and the difference between the two rates. The effective fed funds
rate (in black) and the discount rate (in yellow before 2003 and red after 2002)
compare the level of interest rates—note that since the January 2003 change in
discount window policy the discount rate has exceeded the fed funds rate.
The line centered on zero in the chart is the difference between the two interest
rates; it is calculated as the fed funds rate less the discount rate. Before 2003,
the line showing the difference between the two interest rates (shown in orange)
indicates that the funds rate typically was above the discount rate by a small
margin. However, since the change to a “penalty” discount rate policy in January
2003, the funds rate (shown in pink) has been consistently below the discount
rate.
85
Chart 1
Endnotes
1A bank’s reserve requirement is determined by a percentage the amount of deposits a
bank has, so each bank’s reserve requirement is different. For current reserve
requirements, please see Reserve Requirements of Depository Institutions at:
http://www.federalreserve.gov/monetarypolicy/reservereq.htm.
References
Instruments of the Money Market. (1998) Federal Reserve Bank of Richmond.
http://www.rich.frb.org/pubs/instruments/
Selected Interest Rates (H.15 Release). Board of Governors of the Federal Reserve
System. http://www.federalreserve.gov/releases/
U.S. Monetary Policy: An Introduction. (2004) Federal Reserve Bank of San Francisco.
http://www.frbsf.org/publications/federalreserve/monetary/index.html
86
Money Demand
The other half of the money market - money demand
There are two main determinants of money demand
First – real income – if your real income goes up you will live a better life and in order to
live a better life you consume more and in order to consume more you need to hold more
money. Graphically, an increase in real income shifts the money demand curve to
the right and is exactly how the LM curve is derived (to be shown shortly).
Second – the cost of holding money is the interest rate – the higher the interest rate, the
higher the cost of holding money so the less money you will hold. This idea gives us a
negatively sloped money demand as shown below.
i
6
A
B
4
Md (Y,PS)
400
440
M
When rates are 6 percent, people hold 400 in money balances – quite costly to hold
money. An extreme case may help bring the point home – suppose for a second that rates
are 100% - how much money would you hold? A meals worth? Now suppose rates are
zero, how much money would you hold? Get the picture?
The variables in parentheses are shift variables – as noted before, a higher real income
means more transactions and more transactions require people to hold more money. The
PS term is included and stands for portfolio shocks – think again about Y2K. People
wanted to hold more money not because of a change in interest rates nor a change in real
income – they just wanted to readjust their portfolios due to Y2K. This would be
depicted as a rightward shift in money demand.
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PRACTICE PROBLEMS
An ‘old’ Homework Assignment
PLEASE BE AS NEAT AS POSSIBLE
Pretend you are in charge of conducting monetary policy.
Initial Conditions
rr/D= .10
C = 400 b
D = 1200 b
ER = 10
M=C+D
1)
a) Calculate the MB.
b) Calculate the money multiplier.
c) What is the money supply (use MS = m x MB)?
Please show all work
2) If Rd = 300 – 40 iff, given the information above, what is the market clearing federal
funds rate?
Draw a reserve market diagram depicting exactly what is going on here! Label the
equilibrium point as point A.
3) Suppose that the ff rate that clears the market in 2) above happens to be the federal
funds target that policy makers are happy with (i.e., they feel it’s in line with hitting their
ultimate objectives). If you were in charge of the operational aspect of the desk, that is, if
you were in charge of “hitting” the fed funds target, what must you do on a daily basis?
Be very specific!
88
4) Suppose that due to whatever reason, reserve demand changes and you forecast the
reserve demand to now be Rd = 250 – 40 iff
a) In order to keep the fed funds at target, what must the open market desk do? Be
specific and show this development in your picture above (label the new equilibrium as
point B).
b) Suppose the alternative, that the open market desk does nothing different, that is, they
hold the amount of reserves constant (the fed holds the money stock). What happens in
the reserve market? What is the market clearing fed funds rate now? Label this
development, that is, the new equilibrium as point C.
5) Let’s move on to the money market now.
a) Suppose the money demand function is given by:
Md = 2211 – 100i
What is the market clearing interest rate in the money market?
Show all work
b) Draw a money market diagram and label this initial equilibrium as point A.
89
Consistent with the shock to reserve demand, money demand also decreases. The “new”
money demand curve is now:
Md = 2011 – 100i
c) If the desk acts as they did in part 4) a), to keep the fed funds rate at target, what
would be the new market clearing interest in the money market? Show these
developments on your money market diagram and label this equilibrium as point B.
d) Now suppose the desk “Holds the money Stock,” what would be the market clearing
interest rate now? Label this equilibrium as point C.
e) Since you are the captain of the ship, how would you make your decision on whether
or not to conduct any open market operations? That is, tell me a nice detailed story as to
what goes into making this decision. There is a lot to discuss!
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ANOTHER PROBLEM
Initial Conditions
rr/D= .05
C = 200 b
D = 800 b
ER = 10
M=C+D
a) (3 points)
a) Calculate the MB.
b) Calculate the money multiplier.
c) What is the money supply (use mm x MB to calculate this)?
Show work
b) (3 points) If Rd = 290 – 60 iff, given the information above, what is the market
clearing federal funds rate?
Show work
(4 points for correct diagram) Draw a reserve market diagram depicting exactly what is
going on here! Label the equilibrium point as point A.
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c) (2 points) Suppose that the ff rate that clears the market in 2) above happens to be the
federal funds target that policy makers are happy with (i.e., they feel it’s in line with
hitting their ultimate objectives). If you were in charge of the operational aspect of the
desk, that is, if you were in charge of “hitting” the fed funds target, what must you do on
a daily basis? Be very specific!
d) Suppose that due to whatever reason, you forecast the reserve demand to be:
Rd = 300 – 60 iff
e) (2 points) In order to keep the fed funds at target, what must the open market desk do?
Be specific and show this development in your picture above (label the new equilibrium
as point B). In fed language, this is referred to as accommodating the shock to reserve
demand.
Show work
f) (2 points) Suppose the alternative, that the open market desk does nothing different,
that is they hold the amount of reserves constant (“the fed holds the money stock”). What
happens in the reserve market? What is the market clearing fed funds rate now? Label
this development, that is, the new equilibrium as point C.
Show work
Let’s move on to the money market now.
Suppose the money demand function is given by :
Md = 1500 – 100i (when Y = 4000)
g) (2 points) What is the market clearing interest rate in the money market?
Show all work
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h) (4 points for correct diagram) Draw a money market diagram (use space below) and
label this initial equilibrium as point A.
Consistent with the shock to reserve demand, money demand also increases. The “new”
money demand curve is now:
Md = 1600 – 100i
i) ( 2 points) If the desk acts as they did in part 4) a), to keep the fed funds rate at target,
what would be the new market clearing interest in the money market. Show these
developments on your money market diagram and label this equilibrium as point B.
Show work:
j) (2 points) Now suppose the desk “Holds the money Stock,” what would be the market
clearing interest rate now? Label this equilibrium as point C.
93
Chapter 4: Financial Crises
Asian Crisis Notes
We first look at the events leading up to the Asian Crisis in S. Korea. Much of the
following material was obtained from “South Korea: The Country that Invested its way
into Trouble,” Thursday, January 15, 1998, Financial Times, by John Burton and Gerard
Baker.
Early 1993 - Kim Young-sam became president - he was a populist politician and took
office during a mild recession. He promised to boost growth. He did so by encouraging
Korea’s giant diversified conglomerates, or Chaebol, to invest heavily in new factories.
Korea enjoyed an investment-led economic boom in 1994-1995, but at a cost. The
Chaebol, always heavily reliant on borrowing, now had huge debts - four times equity
on average - and excess production capacity (they were too big!).
In 1996, overcapacity led to falling prices for the nation’s main export products. Prices
for computer memory chips, Korea’s largest export, collapsed in a glutted global market.
Earnings of chip makers fell by 90%. Cars, shipbuilding, steel and petrochemicals were
also affected.
Short-term foreign borrowing by industrial groups rose rapidly as they struggled to
service their long-term debts. Foreign loans were particularly attractive to the
Chaebol since they carried lower interest rates than domestic loans, which reflected
a capital shortage that resulted from Korea’s closed financial markets.
(note: prescriptions from the IMF included breaking up the Chaebol as well as opening
up financial markets)
The corporate debt bomb was primed to explode.
January 1997 - Hanbo Steel collapsed under $ 6 billion in debts - the first conglomerate
(Chaebol) to fall. Hanbo was a prime example of the Crony Capitalism that pervaded
(saturated) S. Korea. Crony Capitalism is where politics and business are intertwined.
Banks had been forced by the government to lend to the steel maker.
Politics played a big role here. President Kim forced through a labor law during a secret
session of parliament in early January. The labor union went on strike for three weeks
and Kim lost his authority (labor unions in S. Korea are very powerful). Given the loss
of authority and the close connection of the government and banks, the banks felt strong
enough to refuse to provide more loans to Hanbo.
Political scandals erupted and in March 1997, Kim appointed a new finance
minister Mr. Kang (his 7th). Kang took over a ministry that was notorious for being
opposed to economic reforms. Mr. Kang vowed to change the ministry from being
opposed to economic reforms to being supportive of them (he was a firm believer in
94
free market principles). Within days of Kang’s appointment, Sammi Steel, Korea’s big
specialty steel maker was allowed to fail.
By now the wider Asian crisis was under way, sapping confidence in Korean
companies as well the Korean currency (won). Kang’s commitment to free market
reforms was put to the test in July 1997 when Korea’s third largest carmaker (Kia) ran
out of cash and asked for emergency bank loans to avoid bankruptcy. At the same time,
Korea’s largest liquor group, Jinro, became the third conglomerate to go bust in 1997.
Given the financial troubles of the Chaebol, the international credit agencies began to
downgrade the ratings for the banks with heavy exposure to the troubled Chaebol.
By October 1997, Kim was under intense pressure and intense criticism for
refusing to bail out Kia. Politics are very relevant here as presidential elections were
coming up in December, and Kim was by no means a “shoe-in” for reelection. So on
October 22, 1997, Kim relented. After the banks refused to provide loans to Kia, Kim
nationalized the carmaker.
Standard & Poor’s (a US credit rating agency) promptly downgraded
Korea’s debt. By coincidence, this decision to nationalize Kia came at the same time as
the speculative attack on the Hong Kong dollar and the crash of the Hong Kong Stock
market.
The two events triggered an outflow of foreign capital as investors dumped their
holdings of Korean equities and bonds (note - there is a debate on whether flows of
foreign capital should be restricted - Greenspan, among many others, is against restricting
the free flow of capital). Foreign banks began to refuse to roll over short-term loans to
Korea. By early November (1997), the slide in the won was accelerating. Foreign
currency reserves started the month at $30 billion and within two weeks, were slashed
in half (the central bank pulled wons off of the market by purchasing them with foreign
currency reserves, hoping to maintain its value relative to the US dollar).
Korean officials began scrambling to enlist direct US and Japanese support hoping to avoid the strict conditions that the IMF would impose. The US Treasury
quickly made it clear that their requests would be fruitless.
Korean officials then pursued commercial banks in hopes that they would agree to
reschedule Korea’s massive foreign debt. For a few days, commercial bankers tossed
around the idea and after a few days, it was clear that this strategy would fail as well.
Korean officials feared that the news of negotiations would be interpreted as a
moratorium on Korea’s debt. Capital would flow out of every emerging market (Korean
banks were also exposed heavily to other emerging markets). The officials felt that it was
best to let the IMF handle it.
On the night of Thursday, November 13, Mr. Kang, the finance minister, the
central bank governor, and the president’s chief economic adviser decided that Korea had
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no choice but to call in the IMF. Mr. Camdessus (head of the IMF) was asked to come
secretly to Seoul that weekend.
During the meeting with Mr. Camdessus, Mr. Kang proposed to announce the
request for an IMF rescue the following Wednesday, November 19, 1997. The
announcement would be linked to two reform packages:
1.
Immediate new laws to improve the government’s financial supervision; give
independence to the central bank on monetary policy; and require consolidated
accounts from the Chaebol (increase transparency).
2.
Widen access to Korea’s financial markets for foreign investors and ease trading
limits on the won.
An indication of the change in policy came on Monday, November 17 when the
won was allowed to drop below the psychological threshold of 1,000 to the US dollar as
the central bank abandoned intervention in the foreign exchange market. But Kang’s
plans quickly unraveled. The very next day, on Tuesday, November 18, the parliament
refused to pass the financial reform laws. On the morning of the day scheduled for the
IMF request announcement, Kang (the finance minister) was sacked!!
Kim figured that Kang was not the right man to negotiate with the IMF. Instead,
Kim appointed Lim Chang-yuel, the trade and industry minister to replace Kang. Lim
had a reputation as being a tough negotiator. He also served with the IMF in the late
1980s, which might help him get a “better deal” for Korea.
On the day of the originally proposed Kang announcement, Lim announced his
own financial stabilization package. The daily trading ban for the won was widened to
10 per cent from 2.5 per cent (Kang wanted to widen it to 15 per cent). Lim also
announced a 10 billion won government fund to liquidate bad bank loans (banks were
hurting - the Chaebols were not paying their debts) and the government promised to
merge “shaky” financial institutions (the IMF wanted Korea to let these shaky banks fail very difficult (politically) to do in S. Korea given the Crony Capitalism).
These announcements were in line with Kang’s plans but there was no request
to the IMF! Since there was no request, the won dropped 10% the next day (November
20). Lim hastily called a news conference the next night and formally announced a
Korean request for $20 billion in stand-by IMF loans. The following week, a team of
IMF officials arrived to begin formal negotiations.
Back in Washington DC, the pace of negotiations was intense. The Thanksgiving
holiday was one to remember for at least three senior members of the Clinton
administration - as their families complained that their Thanksgiving Dinners were
interrupted by lengthy conversations between the Treasury, the White House, and S.
Korea.
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Among other things, foreign policy issues were at stake. “This was happening in
a country that faced a million enemy soldiers across its border,” said one US official.
North Korea had problems of its own, but the US feared that N. Korea would take
advantage of S. Korea’s susceptible position. With 37,000 US troops in S. Korea, the US
interest in resolving the crisis was clear.
On the morning of Friday, November 28, 1997, Kim got a phone call from
President Clinton that would drastically speed up the pace of the IMF negotiations with
S. Korea. The US felt that S. Korea was close to defaulting in the first week in
December. For 15 minutes, Clinton outlined the dire situation that Korea confronted and
suggested a deadline of Monday, December 1, 1997 for the end of the IMF negotiations.
He warned that S. Korea would be “severely punished” by the international financial
community if a deal was not quickly reached. He promised US financial support as a
second line of defense if an accord was reached.
Shaken, Kim ordered Lim to reach an IMF agreement by December 1. Frantic
negotiations were conducted over that weekend - by Sunday night, Lim announced that
an agreement had been reached.
The claim was premature. Mr. Camdessus, who was in Kuala Lumpar at the time,
refused to approve the deal because S. Korea was still reluctant to close down insolvent
financial institutions. He flew to Seoul to intervene directly. During a courtesy call to
Kim, he insisted that the three presidential candidates (election was on December 18)
must promise, in writing, to obey the proposed agreement.
Koreans felt that Camdessus’s demand was arrogant. After an initial refusal, Kim
saved face by compromising the demand: the candidates would address their promise of
support to Kim himself, rather than the IMF. Camdessus continued to discuss the
problem of insolvent banks with the finance minister, Mr. Lim.
A scheduled luncheon in which Mr. Camdessus was to host Korean financial
officials and ambassadors from Western nations that would contribute to the bail out
went ahead on schedule. Mrs. Camdessus hosted the luncheon in her husband’s place.
During the luncheon she (a former nurse) pointedly told the Korean officials that “the
one thing that I learned from the medical profession was that it was not only the
medicine that counted, but the way that the patient takes it.”
Mrs. Camdessus’s remark proved prophetic. A $55 billion IMF deal was signed
that evening - and started unraveling almost immediately.
On December 8, 1997, a leading Korean newspaper revealed a confidential IMF
document that said Korea’s short term foreign debt was more than $100 billion,
nearly twice as big as previously thought. The same day, Lim announced that the
government would take over Korea’s two weakest banks - instead of closing them as
the IMF conditions called for. And Daewoo, one of the Chaebols, bought debt-laden
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Ssangyong Motors under a deal that forced Ssangyong’s creditor banks to share much of
the financial burden.
Due to these events, foreign banks questioned S. Korea’s commitment to
undertaking and then abiding by the IMF reforms. Overseas banks refused to roll over
loans, foreign investors fled the Seoul bourse (Korean stock market), and the won
“dropped like a stone.”
Critics of the IMF argued that the conditions it was imposing were too strict.
Other critics complained that the US was contributing to a bailout that would save
Western banks from facing up to the consequences of imprudent lending (the moral
hazard problem).
Korean Politics
Kim Dae-jung, the veteran centre-left opposition leader, took advantage of the
popular unhappiness over the IMF deal. His party proclaimed December 3 as “national
economic humiliation day.” He criticized the IMF agreement as representing a “loss of
economic sovereignty.” Promising to renegotiate the deal’s terms to avoid job losses,
Mr. Kim received a bounce of support that made him the front-runner.
As foreign investors reacted to Mr. Kim’s (Dae-jung) lack of support of the IMF
plan, Mr. Lee Hoi-chang, the government candidate, accused him of worsening the
nation’s financial turmoil with “irresponsible” remarks. Mr. Kim retreated and sent a
letter to Mr. Camdessus promising full compliance with the IMF’s terms. Kim Dae-jung
won the presidential election by a narrow margin.
Shortly after the election, Kim sent Kim Ki-hwan, Korea’s roving ambassador for
economic policy, to discuss a new financial aid package with the US.
The reason was that despite the initial inflow of IMF funds, Korea would exhaust
its foreign currency reserves by the end of the month. The ambassador hoped to
persuade the IMF, the US, and other lenders to speed up payment of the next installment
of funds. The ambassador arrived in Washington DC on December 18 carrying a new set
of proposals known as “IMF plus.”
In a meeting with Lawrence Summers, the deputy US Secretary of the Treasury,
the ambassador admitted that Korea was days away from a debt moratorium. He
promised that Korea would support tougher measures in return for aid.
Initially, the US was unenthusiastic - Robert Rubin (the US Secretary of the
Treasury) was still confident that Korea would not need an accelerated payment program.
The attitude did not last. At dinner that evening (December 18), Rubin, Greenspan and
others worried that a Korean default would cause a banking crisis in Japan - Japan held
$25 billion in Korean debt. They also worried about financial turmoil in other emerging
markets where Korean banks were heavy investors. Something had to be done.
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The shift in the US approach was followed by reassurance from Korea. The
president stated that his top priority was to improve Korea’s economic competitiveness
rather than protect job security.
On the same day (December 22) Moody’s investor service and Standard &
Poor’s, the leading US credit agencies, reduced Korean state and corporate bonds to junk
bond status (junk status is as low as it gets).
The final details of the “IMF plus” proposal were being negotiated with the
finance ministry, including the rapid opening of financial markets to overseas investors.
At the stroke of midnight on Christmas Eve, Lim announced that the IMF and eight
country lenders had agreed to advance $10 billion to Korea to prevent a debt default. The
worst seemed to be over.
Brief Chronology of the E. Asian Financial Crisis; June 19 through October 23,
1997 - The Meltdown
June 19 - Amnuay Viravan, staunchly against devaluing the baht, resigns as Thailand's
finance minister. The Prime Minister, Chavalit Yongchaiyudh says: "We will never
devalue the baht." The resignation has immediate financial impact in the Philippines,
where the overnight (interest) rate rises to 15 percent.
June 27 - The Thai central bank suspends operations of 16 cash-strapped finance
companies and orders them to submit merger or consolidation plans.
June 30 - Thai Prime Minister Chavalit Yonchaiyudh assures the nation in a televised
address "that there will be no devaluation of the baht."
July 2 - The Bank of Thailand announces a managed float of the baht and calls on the
International Monetary Fund for "technical assistance." The announcement effectively
devalues the baht by about 15-20 percent. It ends at a record low of 28.80 to the dollar.
This is the trigger for the East Asian crisis. In Manila, the Philippines central bank is
forced to intervene heavily to defend the peso.
July 3 - The Philippine central bank raises the overnight lending rate to 24 percent from
15 percent.
July 8 - Malaysia's central bank - Bank Negara has to intervene aggressively to defend
the ringgit. The intervention works and the currency hits a high of 2.5100/10 after a low
of 2.5240/50.
July 11 - The Philippine central bank says in a statement it will allow the peso to move in
a wider range against the dollar. The IMF backs the move and Managing Director
Camdessus says he would recommend the IMF board approve the Philippines' request for
an extension of its Extended Fund Facility (EFF). In Indonesia, the rupiah is starting to
be affected. In a surprise move, Jakarta widens its rupiah
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trading band to 12 from 8 percent.
July 14 - The IMF offers the Philippines almost $1.1 billion in financial support under
fast-track regulations drawn up after the 1995 Mexican crisis. The Malaysian central
bank abandons the defense of the ringgit.
July 17 - The Singapore monetary authority allows the depreciation of the S$. It falls to
its lowest level since February 1995.
July 24 - Currency meltdown. The ringgit hits 38-month low of 2.6530 to the dollar.
Malaysian Prime Minister Mahathir Mohamad launches bitter attack on "rogue
speculators." The Hong Kong dollar remains steady, but Hong Kong later reveals US$1
billion was spent on intervention during a period of two hours on an unspecified day in
July.
July 26 - Malaysian PM Mahathir names hedge fund manager George Soros as the man
responsible for the attack on the ringgit. He later brands Soros a "moron."
July 28 - Thailand calls in the IMF.
Aug. 5 - Thailand unveils austerity plan and complete revamp of finance sector as part of
IMF suggested policies for a rescue package. Central bank suspends 48 finance firms.
Aug. 11 - The IMF unveils in Tokyo a rescue package for Thailand including loans
totaling $16 billion from the IMF and Asian nations.
Aug. 13 - The Indonesian rupiah begins to come under severe pressure. It hits a historic
low of 2,682 to the dollar before ending at 2,655. The central bank actively intervenes
in its defense.
Aug. 14 - Indonesia abolishes its system of managing the exchange rate through the use
of a band and allows it to float. The rupiah plunges to 2,755. Bank Indonesia tries
mopping up liquidity with high interest rates.
Aug 15 - Speculators attack Hong Kong dollar; overnight interest rates up 150 basis
points from previous day to 8%. Stock market sharply lower.
Aug. 16 - An unnamed Beijing source tells a local Hong Kong newspaper that China is
prepared to use US$50 billion to defend the Hong Kong dollar.
Aug. 20 - IMF approves a $3.9 billion credit for Thailand. The package now totals $16.7
billion.
Aug. 23 - Malaysian PM Mahathir Mohamad blames US financier George Soros for
leading attack on East Asian currencies: "All these countries have spent 40 years
trying to build up their economies and a moron like Soros comes along."
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Sept. 4 - Carnage in the Philippine peso continues. It falls to a record low of 32.43 to the
dollar before central bank intervention helps it up slightly to end at 32.38. Malaysian
Ringgit breaks through 3.0000 to the dollar barrier. Mahathir delays several multi-billion
dollar construction projects.
Sept. 16 - Indonesia says it will postpone projects worth 39 trillion rupiah in an attempt
to slash the budget shortfall.
Sept. 20 - Mahathir tells delegates to the IMF/World Bank annual conference in Hong
Kong that currency trading is immoral and should be stopped.
Sept. 21 - Soros says "Dr. Mahathir is a menace to his own country."
Oct. 1 - Mahathir repeats his siren call for tighter regulation, or a total ban, on forex
trading. The currency falls four percent in less than two hours to a low of 3.4080.
Oct. 6 - The Indonesian rupiah hits a low of 3,845.
Oct. 8 - Indonesia says it will ask the IMF for financial assistance.
Oct. 14 - Vietnam, bowing to months of pressure on its dong currency, doubles the
permitted trading range to 10 percent on either side of the daily official rate.
Devaluation of the Taiwan dollar.
Oct. 17 Friday - Malaysia presents a belt-tightening budget to try to stop the economy
from sliding into recession.
Oct. 20-23 Monday - Thursday - The Hong Kong stock market suffers its heaviest
drubbing ever, shedding nearly a quarter of its value in four days on fears over interest
rates and pressures on the Hong Kong dollar. The fall, more severe than the 1987 crash,
forces the Hang Seng index down 23.34 percent down to 10,426.30 at Thursday's close,
after 13,601.01 the previous Friday. The devaluation of the Taiwan dollar the previous
week, the latest in a string of Southeast Asian currency devaluations, created doubt about
Hong Kong changing its long-standing peg to the U.S. dollar."I think the biggest thing to
scare Hong Kong was the devaluation in Taiwan," said John Bender, vice president at
HSBC James Capel. "[Taiwan] is a country with substantial foreign exchange reserves."
In short, Taiwan is a lot like Hong Kong and Taiwan was unable to keep up the link.
Taiwan's dollar has fared poorly since the devaluation, dropping about 5 percent, and is
currently valued at 30.23 to the U.S. dollar. The Hong Kong dollar is at about 7.50 to the
U.S. dollar.
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Causes of the East Asian Crisis (also read pages 189 – 198 –Mishkin, Chapter 8 –
Seventh Edition)
The causes of the Asian Crisis will be debated for some time. The following
article is a good place to start (also see Greenspan’s prepared text “Lessons from the
Global Crises” that follows the Russian Crisis notes).
Wall Street Journal, February 4 ,1998
Too Much Government Control
By CHARLES WOLF JR.
Asia's financial earthquake is the second biggest international surprise of the past decade.
The first, and weightier, one was the demise of the Soviet Union. Like the 1991 Soviet
shock, Asia's financial hemorrhaging has had many causes. The ensuing debate has
largely focused on their relative importance.
The primary cause of the Asian crisis, however, has been largely obscured: namely, the
legacy of the so-called Japanese development model, and its perverse consequences.
Subsequently relabeled the Asian development model as its variants were applied
elsewhere in the region, this strategy of economic growth has been grandly extolled in the
past two decades. Its strongest proponents included Eisuke Sakakibara, presently Japan's
vice minister of finance, Malaysian Prime Minister Mahathir Mohamad, and such
Western commentators as Karel van Wolferen, Chalmers Johnson, James Fallows and
Clyde Prestowitz. What we are now seeing in Asia's financial turbulence are the
model's accumulated shortcomings.
This is not to deny the role of other proximate causes, including short-term borrowing by
Asian banks and companies, and their long-term lending or investing; the failure of the
money-center banks in Japan, the U.S. and Germany that provided the mounting shortterm credit to exercise due diligence; and foreign investors' unrealistic assumptions that
Asian currencies' pegs to the U.S. dollar would be maintained. But these proximate
causes are traceable to or abetted by the primary cause: widespread insulation from
market forces.
The Asian development model began with a conceptual framework largely built by
American and Japanese academic economists. Central to it is the phenomenon of "market
failure": the predictable inability of market mechanisms to achieve maximum efficiency
and to encourage growth when confronting "economies of scale" and "path dependence."
These conditions may lead to monopolies in the advanced economies and the extinction
of competition from late-starters in the development process. If the objectively based
decisions of the marketplace are recognized to have such predictable shortcomings, the
argument has run, then subjectively based decisions by government agencies or key
individuals could improve upon market outcomes.
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In the original version of the model, these subjective judgments were provided by Japan's
Ministry of International Trade and Industry and Ministry of Finance, in collaboration
with targeted export industries believed to be associated with economies of scale. MITI
and the Ministry of Finance tagged these "winners" to receive preferred access to
capital, as well as protection in domestic markets through the use of tariffs or
nontariff barriers to limit foreign competition.
In the Korean variant of the model, the subjective judgments as to who and what would
receive preferences--often the same industries targeted by Japan--were exercised by the
president, the industrial conglomerates and these chaebols' associated banks. In the
Indonesian variant, the subjective oracular sources have been President Suharto and his
extended family and hangers-on, in conjunction with B.J. Habibie's self-styled
technological community at the Ministry of Research and Technology.
To be sure, the Japanese model and its variants produced noteworthy accomplishments.
Vast amounts of savings and investment were mobilized for and channeled to the
anointed industries and firms. While substantial resources were wasted in the process--for
example, MITI's blunders in the case of steel, shipbuilding and aircraft--the scale of
resource commitments led to world-class performance in other cases--notably in cars,
consumer electronics, telecommunications equipment and semiconductors in Japan,
similar heavy-industrial development in Korea, and light-industry development in
Indonesia.
But the negative effects of the Asian model were cumulatively enormous, including the
following:
Wasted resources when non-market choice processes made mistaken decisions, such as
Indonesia's large investments in a national car and in a domestic aircraft industry. These
non-market failures account for the fact that Asia's economic growth has been mainly due
to large inputs of capital and labor, with relatively limited improvement in
productivity. Structural imbalances due to overemphasis on export industries and
neglect of the domestic economy. As a result, domestic production has been
shortchanged, and consumption standards held down in favor of aggressive pursuit
of export markets. Excess capacity has been built up in export industries through
the arbitrary processes of "picking winners." Failure to take adequate account of
demand saturation while production continued to expand has contributed to
currency depreciation, falling prices and sharply adverse changes in Asia's terms of
trade. A sense of hubris among the favored industries, firms and individuals. When
these entities confronted market tests that they could not meet, they and their foreign
lenders expected to be bailed out with additional resources, often publicly funded or
guaranteed. Whether the shortfall was in an old-line major banking house (Japan's
Yamaichi Securities), or an established conglomerate (Korea's Halla group), or the startup of questionable new ventures (Indonesia's Timor car), it was expected that some nonmarket (i.e., government) preference would make up the difference. The favoritism,
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exclusivity and corruption of the Asian model's back-channel and nontransparent
decision making has had a corrosive effect on the societies and polities of the
region.
That market-mediated allocations of resources have shortcomings doesn't imply that the
Asian model's subjectively mediated ones will not have still greater shortcomings. In fact,
the legacy of the Japanese model and its Asian variants suggests that their associated
shortcomings are enormously greater, because they tend to be protected and concealed.
Lacking the corrective, mediating responses that market mechanisms and incentives
provide, the shortcomings accumulate until a systemic breakdown occurs.
If this lesson is heeded, Asia's recovery can be rapid and enduring; if it is not, recovery is
more likely to be slow and fitful--and ultimately far more painful.
Mr. Wolf is senior economic adviser and corporate fellow in international economics at
RAND.
Copyright: Wall Street Journal, 1998.
Notes on Wolf Article
The Japanese model does not rely on free market principles. By this I mean that
the methods of allocating scarce resources are not based on the forces of supply and
demand. Rather, the allocation problem is primarily determined by the government. In
economic jargon, the allocation problem is determined by a Command and Control
System. The government tries to pick “winning industries” and then proceeds to give
them favorable treatment. Sooner or later, the inevitable mis-allocation of resources
(shortcomings of the system) will build, especially since they tend to be “protected and
concealed.”
Factors Relevant in causing Crisis
1.
Short term borrowing in unhedged US dollars, Yen, and Marks - by unhedged,
we mean that the East Asian borrowers did not protect (buy insurance, hedge)
themselves from the currency risk associated with borrowing in a foreign currency.
When these currencies devalued, the foreign currency-denominated loans (e.g., dollar
loans) became drastically more expensive to service (pay off). Why was there no
hedging against currency risk? The borrowers must have felt that the odds of their
currency depreciating were rather low. Recall that all these currencies were pegged
to the US dollar. In previous years, the Asian countries had little trouble maintaining
their dollar peg (a dollar peg is similar to but not exactly like a fixed exchange rate
with the dollar). In fact, if anything, there was often pressure for their currencies to
appreciate. Why? Lots of foreign financial capital was flowing into these countries
and therefore the demand for their currencies was high. Since the demand was high,
their currencies would have pressure to appreciate as opposed to depreciate. Think
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about it. When investors started to flee - they dumped wons, rupiah, etc., on their
markets. The increase in supply put a lot of downward pressure on their currencies.
Before the fleeing, the opposite occurred (capital “in-flight” as opposed to capital
flight).
Borrowers can hedge against foreign currency risk by buying future contracts,
forward contracts and/or options. Suppose you are a borrower from S. Korea and you
know that three months from now, you will owe Citigroup bank $1 million. Your income
is denominated in wons. You can buy a forward contract that will guarantee you a
dollar/won exchange rate three months from now, regardless of what happens to the
actual dollar/won exchange rate. Thus, if your currency goes through the floor, you are
protected since you have a guaranteed dollar/won exchange rate. Options are similar
except that they are more flexible. You simply have the option to exercise your agreed
upon dollar/won exchange rate (set by the option contract). In hindsight, the E. Asian
banks and firms should have hedged (bought insurance on) their foreign-denominated
debt.
2.
Low returns in equity markets in Japan and Western Europe - Investors were
seeking higher returns and East Asian equity markets offered them - they
appeared to be a sure bet. There was a huge influx of “hot money” which made
matters precarious. What eventually happened is that this hot money reversed
direction - in fact, it went out faster than it went in. Central banks were scrambling
for foreign reserves to intervene in hopes of maintaining their (currency) peg to the
US dollar. Another relevant factor is that the equity markets in the East Asian
countries were becoming inflated. The more money that came in, the higher the
valuation in the respective equity markets. Given that many borrowers use their stock
holdings (banks included!) as collateral on loans, when the value of their stock
holdings plummeted, so did the value of their collateral. This is another factor that
increased the likelihood of default (along with currency depreciation).
3.
Low interest rates in the US and Japan made borrowing attractive to the East
Asian borrowers. Simply put, it was or at least appeared to be, cheaper borrowing
abroad than borrowing at home.
4.
Japanese Model (See “Too Much Government Control” above)
A.
B.
Command and Control Elements
Preferential treatment to “chosen” export industries
i.
Preferred access to financial capital
a. offered below market interest rates
b. direct subsidies
c. “unlimited” funding
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ii.
Protection
a. Tariffs
b. Quotas
C. Over capacity led to low export prices, pressure to devalue, firms defaulted on
loans.
D. Inadequacies of Model
i.
ii.
iii.
iv.
Favoritism
Exclusivity
corruption
subjective decision making
Other factors relevant in causing crisis:
5.
Exchange rates were pegged to the US dollar for too long.
From “Anatomy of a Currency Crisis,” by Jane Little
Investors seeking higher returns quickly spotted the Southeast Asian countries, which
were gradually opening their capital markets to foreigners. These “tiger” economies
were growing fast. By LDC standards, their inflation was moderate and their fiscal
positions prudent. Moreover, currency risk must have seemed small since these countries
had long pegged or nearly pegged their currencies to the U.S. dollar. Small, open
economies sometimes choose to peg their exchange rates, at least for a time, to
encourage trade and investment, to anchor domestic prices, and to signal their
commitment to sound monetary policies. With these many attractions, Southeast Asia's
miracle countries have experienced huge capital inflows in recent years.
But, with exchange rates fixed, capital inflows to purchase Thai securities or to expand
an Indonesian manufacturing plant required that their central banks buy dollars and
supply the needed baht or rupiahs, ballooning the money supply. Central bank efforts
to offset these flows, by selling government securities, say, raised domestic interest
rates and encouraged further inflows. With inflation even modestly above U.S. levels
and exchange rates fixed, these countries' products became relatively costly on world
markets. Several developments magnified their problem. The 1994 devaluation of the
yuan made China more competitive; the yen's slide against the U.S. dollar made
matters worse. Finally, Taiwan's entry into the chip market brought a glut in a major
regional industry. So when world trade slowed in 1995-96, one of the first signs of
trouble for the Asean-4 (Indonesia, Malaysia, the Philippines, and Thailand) was a
deterioration in their current account deficits.
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Summary: If the Asian countries only would have devalued earlier, the export industries
would have remained competitive and thus their income flow may have been sufficient to
pay back their loans and therefore they may not have been “forced” to borrow abroad.
6. Lax banking regulations coupled with capital controls- Again, from “Anatomy of a
Currency Crisis.”
Another yellow flag was the rapid expansion of domestic credit, abetted by lax banking
supervision and rapid deregulation. In Indonesia, state-owned banking gave way to a
system where anyone with $1million or so could open a bank. Because capital controls
continued to deter outflows of domestic capital, much of this new credit flowed into
misguided real estate investments and industries already burdened with unneeded
capacity. In Hong Kong, real estate prices quadrupled in five years, and Malaysia
became home to the world's tallest and longest buildings. Throughout the area,
newcomers to the auto industry -- national favorites, presidents' relatives, electronics
companies, and others -- insisted on pushing their way onto the crowded field. So by late
1996, bank and non-bank borrowers in these countries had taken on large amounts of
foreign debt, much of it short-term, denominated in unhedged dollars, and invested in iffy
projects.
Summary: With lax banking regulations, domestic credit grew rapidly. Given
“domestic” capital controls, this credit had to go somewhere within the country. This
factor added to the over-capacity.
7.
Lack of US support (as in Mexico’s case) as well as bailout being too small - it is
argued that since the United States did not offer Thailand funds independent of the IMF,
as the US did in the early 1995 Mexican bailout; Thailand felt abandoned. From article:
US best experts …
For all this expertise and brilliance, though, they stumbled. The Mexican formula didn’t
fit in Thailand. The biggest difference: Mexico shared a border with the largest and
healthiest economy on the planet; the U.S. pulled Mexico out of recession. The biggest
economy in Thailand’s neighborhood, Japan, weakened as the crisis unfolded, and has
been impervious to U.S. pressure. But that wasn’t obvious in July 1997.
The Treasury pushed the IMF to make a big loan to Thailand, but didn’t offer any
additional U.S. money, a sharp contrast to its decision to offer Mexico $20 billion in early
1995.
The reasons for Mr. Rubin’s tight-fistedness were straightforward. For Mexico, Mr.
Rubin had tapped the Treasury’s Exchange Stabilization Fund, a kitty that he and the
president controlled. Subsequently, an angry Congress slapped restrictions on its future
use. Those restrictions were about to expire when Thailand hit. To avoid provoking
Congress into extending the restrictions, the Treasury kept its wallet in its pocket. “It was
important that we have the freedom to use the ESF when it was needed,” Mr. Rubin says.
He argues that Thailand suffered more from the dithering of its politicians in the summer
of 1997 than from inadequate U.S. aid.
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What seemed reasonable in Mr. Rubin’s office played poorly in Bangkok and elsewhere
in Asia. Thailand felt abandoned, and other Asian governments— as well as some players
in financial markets—wondered if the U.S. would come to their aid if necessary.
8.
Lack of transparency in banks; firm’s balance sheets. Many foreign investors
had no clue how bad things were. When they found out - take your money and run in
herds! This key IMF condition (increased transparency) should help us to avoid this
herding behavior from occurring in the future.
9.
The moral hazard problem - Milton Friedman among others are convinced that the
very existence of the IMF was primarily responsible for the East Asian crisis. From
the WSJ’s editorial page,
October 13, 1998, Friedman writes:
Indeed, Congress and the Clinton administration spent much of the last week's budget
negotiations fine-tuning the details of the U.S.'s latest $18 billion IMF subvention
package. Such talk is on a par with the advice to the inebriate that the cure for a hangover
is the hair of the dog that bit him.
And
The Mexican bailout helped fuel the East Asian crisis that erupted two years later. It
encouraged individuals and financial institutions to lend to and invest in the East Asian
countries, drawn by high domestic interest rates and returns on investment, and reassured
about currency risk by the belief that the IMF would bail them out if the unexpected
happened and the exchange pegs broke. This effect has come to be called "moral hazard,"
though I regard that as something of a libel. If someone offers you a gift, is it immoral for
you to accept it? Similarly, it's hard to blame private lenders for accepting the IMF's
implicit offer of insurance against currency risk. However, I do blame the IMF for
offering the gift. And I blame the U.S. and other countries that are members of the IMF
for allowing taxpayer money to be used to subsidize private banks and other financial
institutions.
Criticisms of the IMF
The following list captures most of the opponents’ view regarding the IMF:
1. IMF policies are conducted in secrecy - consider the following quotes from Jeffrey
Sachs, “IMF is a power unto itself” Financial Times, Thursday, December 11, 1997.
Jeffrey Sachs was the head of the Harvard Institute for International Development at that
time.
“It is time that the world take a serious look at the International Monetary Fund. In the
past three months, this small, secretive institution has dictated economic conditions to
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350m people in Indonesia, South Korea, the Philippines, and Thailand. It has put on the
line more than $100bn of taxpayers’ money in loans.”
While it pays lip service to “transparency”, the IMF offers virtually no substantive
public documentation of its decisions, except for a few pages in press releases that are
shorn of the technical details needed for a serious professional evaluation of its
programmes. Remarkably, the international community accepts this state of affairs as
normal.
The world waits to see what the Fund will demand of country X, assuming that
the IMF has chosen the best course of action. The world accepts as normal the idea that
crucial details of IMF programmes should remain confidential, even though these
“details” affect the well-being of millions. Staff at the Fund, meanwhile, are
unaccountable for their decisions.
The people most affected by these policies have little knowledge or input. In Korea,
the IMF insisted that all presidential candidates immediately “endorse” an agreement
they had no part in drafting or negotiating - and no time to understand.
The situation is out of hand. However useful the IMF may be to the world
community, it defies logic to believe that the small group of 1,000 economists on 19th
Street in Washington should dictate the economic conditions of life to 75 developing
countries with around 1.4bn people.
These people constitute 57 per cent of the developing world outside China and India
(which are not under IMF programmes). Since perhaps half of the IMF’s professional
time is devoted to these countries - with the rest tied up in surveillance of advanced
countries, management, research, and other tasks - about 500 staff cover the 75 countries.
That is an average of about seven economists per country.
One might suspect that seven staffers would not be enough to get a very
sophisticated view of what is happening. That suspicion would be right. The IMF threw
together a draconian programme for Korea in just a few days, without deep knowledge of
the country’s financial system and without any subtlety as to how to approach the
problems.
Consider what the Fund said about Korea just three months ago in its 1997 annual
report. “Directors welcomed Korea’s continued impressive macroeconomic performance
[and] praised the authorities for their enviable fiscal record.” Three months ago there was
not a hint of alarm, only a call for further financial sector reform - incidentally without
mentioning the chaebol (conglomerates), or the issue of foreign ownership of banks, or
banking supervision that now figure so prominently in the IMF’s Korea programme.
In the same report, the IMF had this to say about Thailand, at that moment on the
edge of the financial abyss. “Directors strongly praised Thailand’s remarkable economic
performance and the authorities’ consistent record of sound macroeconomic policies.”
With a straight face, Michel Camdessus, the IMF managing director, now blames
Asian governments for the deep failures of macroeconomic and financial policies that the
IMF has discovered. It would have been more useful instead, for the IMF to ponder why
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the situation looked so much better three months ago, for therein lies a basic truth about
the situation in Asia.
2.
There is a serious moral hazard problem - The argument is that big international
banks downplayed the downside risk of the loans they made to Asian countries since
if there was a crisis, they would eventually be bailed out by the IMF. Again from
Jeffrey Sachs:
“These bailout operations, if handled incorrectly, could end up helping a few
dozen international banks to escape losses for risky loans by forcing Asian
governments to cover the losses on private transactions that have gone bad. Yet the
IMF decisions have been taken without any public debate, comment, or scrutiny.”
It is very difficult to eliminate the moral hazard problem. Jeffrey A. Frankel - member of
the Council of Economic Advisors writes (from “The Asian Model, The Miracle, The
Crisis and The Fund” delivered at the U.S. International Trade Commission, April
16,1998):
Today’s financial markets are like superhighways. They get you where you want
to go fast. By this I mean that they are useful: they help countries finance investment
and therefore growth, and they smooth and diversify away fluctuations. But accidents do
occur, and they tend to be big ones – bigger than they used to be when people were not
able to drive so fast. The lesson is not that superhighways are bad. But drivers need to
drive carefully, society needs speed limits or speed bumps, and cars need air bags. ……
Everyone has now learned about moral hazard, the principle that bailing out
investors and borrowers reduces their incentive to be more careful next time. The moral
hazard point is a correct one, and it enters into the East Asian developments in a number
of ways. But there is a danger of exaggerating it. It is a standard principle of economics
that actions in one area can generate partly offsetting reactions in another. That is not in
itself a reason not to take action. In our highway example, there is research
demonstrating that drivers react to seat belts and airbags by driving faster and less safely
than they used to. But that is not a reason to dispense with air bags. If it were, that logic
would say that to discourage dangerous driving, we should put a spike in the
steering wheel (as Michael Mussa of the IMF says).
3. The IMF charges below market interest rates to risky borrowers (UNFAIR!).
From “An Unreformed IMF Doesn’t Deserve a Dime” By JIM SAXTON
“ Subsidized interest rates encourage economic inefficiency and exacerbate the moral
hazard problem. The standard interest rate charged by the IMF for its bailout loans,
currently under 4.5%, simultaneously encourages unsound lending practices and
promotes high-risk investments.”
And from “The IMF’s Big Wealth Transfer” By DAVID SACKS and PETER THIEL
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“And this is what is taking place. Recent IMF packages to South Korea, Thailand and
Indonesia involve interest rates ranging from 4.6% to 4.8% on dollar-denominated debt
with a maturity of three years. Even the U.S. government has to pay substantially more
(about 5.5%) for debt of that term. What this means is that, even if there were no risk of
default at all, American taxpayers would still be losing money, because the rates at
which they are lending dollars are lower than the rates at which they are borrowing
dollars.”
And:
“Curiously, the U.S. government lends money through the IMF at far lower rates of
interest than it charges to most domestic loans to Americans. In the case of loans
guaranteed by the Small Business Administration, for example, the prevailing interest
rate hovers around 10.75%; university students must pay about 9% on college loans; and
veterans must pay about 7% on federally guaranteed mortgage loans. All of these
borrowers are safer credit risks than East Asian governments.”
One of the conditions for the US $18 billion contribution to the IMF is to push the
interest rate charged by the IMF to 3 percentage points above the “market rate.”
The fund is costly to the U.S. taxpayer. (From article, “The IMF’s Big Wealth
Transfer” by David Sacks and Peter Thiel, WSJ 3/13/98 )
4.
(Repeated from above) And this is what is taking place. Recent IMF packages to South
Korea, Thailand and Indonesia involve interest rates ranging from 4.6% to 4.8% on
dollar-denominated debt with a maturity of three years. Even the U.S. government has to
pay substantially more (about 5.5%) for debt of that term. What this means is that, even if
there were no risk of default at all, American taxpayers would still be losing money,
because the rates at which they are lending dollars are lower than the rates at which they
are borrowing dollars.
5. The IMF Imposes inappropriate policy prescriptions (From Article, “An
Unreformed IMF Doesn’t Deserve a Dime,” by Jim Saxton, WSJ, 9/22/1998). The IMF
frequently imposes inappropriate conditions on countries that request its assistance—
undermining rather than helping the target economies. In Indonesia, for instance, the IMF
called for the end of food and fuel subsidies at a time when millions of people could no
longer afford the necessities of life. These conditions sparked riots and violence that
caused long- term damage to the prospect of economic recovery.
More generally, the common prescription is higher interest rates and government budget
cuts: from article “Missteps of the U.S.’s Best Experts May Have Fostered Economic
Crisis,” by David Wessel and Bob Davis, WSJ, 9/24/1998.
But even early supporters of the Treasury-backed IMF approach are uneasy. Mr.
Greenspan told Congress last week he thought the IMF had “misread the depth of some
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of the really fundamental problems that were involved in the crisis that evolved.” He
added: “I think their actions were somewhat misguided in the early stages.”
In pushing for budget cuts, the IMF was misled by its own optimistic assumptions.
Incorrectly forecasting only mild downturns in Asia, the IMF demanded that
governments reduce spending to offset the expense of restructuring banks. That pulled
money out of economies that, in retrospect, needed more, not less, government spending;
it was like siphoning gasoline out of a truck already low on fuel.
Mr. Rubin now concedes it was an error. “I think they may have been somewhat more
stringent than they should have been.” But he and Mr. Fischer say the IMF called for
easier government budgets as the crisis intensified.
The human cost was greatest in Indonesia, where the IMF insisted on curtailment of fuel
and cooking-oil subsidies. It reasoned that the subsidies required to keep prices from
rising were growing rapidly as the falling rupiah pushed up import costs, threatening
hyperinflation. Indonesia dithered for months, but in May it abruptly cut subsidies and
pushed up gasoline prices by 71%, bus fares by 67% and kerosene and cooking oil by
25%. That sparked riots in which hundreds died, and eventually led to Mr. Suharto’s
resignation.
Few issues are as hotly debated as the currency devaluations that accompanied the
problems in Thailand, Indonesia and Korea. To the IMF and Treasury, devaluations are a
consequence, not a cause, of failed economic policies. When Mexico or Thailand or
Korea ran out of dollars to support their currencies against the assault of the merciless
markets, they had no choice but to let the currencies go down. But in each case, the
devaluations were far deeper than Washington anticipated.
To a set of conservatives who are influential with congressional Republicans,
devaluations are a cause of the problem. They blame the IMF for encouraging such
moves, saying that countries, such as Argentina, that firmly and credibly declare they
won’t devalue are more likely to withstand market attacks.
The Interest-Rate Cure
Neither the Treasury nor the IMF expresses misgivings about advising high interest rates,
even to countries that are as bad off as Thailand, Indonesia and Korea. Tight money is the
classic prescription for countries that need to support a weak currency, since higher rates
generally draw domestic and foreign investors.
But at the World Bank, chief economist Joseph Stiglitz is honing a critique, presented in
detail at a recent Brookings Institution seminar, that high interest rates in Asia did more
harm to highly leveraged businesses than good in terms of boosting exchange rates.
And Jeffrey Sachs, the Harvard economist who worked closely with the IMF in Eastern
Europe and now counsels developing countries to look elsewhere for advice, argues that
high rates spooked investors. “The IMF and the U.S. thought the orthodox approach
would calm markets and the high-profile approach would instill confidence, and they
didn’t,” he says. “They set off a first-class financial panic.”
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The IMF Proponents Response to the Criticisms
1.
IMF policies are conducted in secrecy - The secrecy is very likely going to
dissipate. One argument, probably a weak argument, is that it is possible that the
IMF can prescribe the correct reforms before the international community needs
to know. This line of reasoning relies on the idea that investor and speculator
reactions to “news” tend to be excessive and destabilizing (herding behavior).
2.
There is a serious moral hazard problem - Proponents of the IMF do not deny
the existence of the moral hazard problem, but they do suggest that the moral
hazard problem is often exaggerated. Stanley Fischer writes (“The Asian Crisis:
A View from the IMF”, 1998):
Of course, not everyone agrees with the international community's approach of trying to
cushion the effects of such crises. Some say that it would be better simply to let the chips
fall where they may, arguing that to come to the assistance of countries in crisis will only
encourage more reckless behavior on the part of borrowers and lenders. I do not share the
view that we should step aside in these cases. To begin with, the notion that the
availability of IMF programs encourages reckless behavior by countries is far-fetched: no
country would deliberately court such a crisis even if it thought international assistance
would be forthcoming. The economic, financial, social, and political pain is simply too
great; nor do countries show any great desire to enter IMF programs unless they
absolutely have to.
On the side of the lenders, despite the constant talk of bailouts, most investors have
made substantial losses in the crisis. With stock markets and exchange rates plunging,
foreign equity investors have lost nearly three-quarters of the value of their equity
holdings in some Asian markets. Many firms and financial institutions in these countries
will go bankrupt, and their foreign and domestic lenders will share in the losses.
International banks are also sharing in the cost of the crisis. Some lenders may be forced
to write down their claims, especially against corporate borrowers. In addition, foreign
commercial banks are having to roll over their loans at a time when they would not
normally choose to do so. And although some banks may benefit from higher interest
rates on their rollovers than they would otherwise receive, the fourth quarter earnings
reports that became available indicate that, overall, the Asian crisis has indeed been
costly for foreign commercial banks.
3. The IMF charges below market interest rates to risky borrowers. - Again, this
will certainly change - the proposal is to charge 3% higher than the “market rate.” People
will still argue that the 3% premium is not enough to reflect the associated default risks
with the loans. As far as the IMF reaction is concerned, I imagine they would argue that
these affected countries are so bad off that it is reasonable to give them a break
(humanitarian). Charging low rates will also increase the probability of payback.
Naturally, the higher the rate that the IMF charges borrowers, the higher the chance of
default. Perhaps the IMF is worried about its credibility as well as (losing) its power.
Think about it - if there are a lot of IMF deadbeat debtors, society will want to know
what’s going on within the IMF. Once the IMF loses its secrecy, the loss of (exclusive)
power and influence is likely to follow.
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4.
The Fund is costly to the US taxpayer - proponents of the IMF would argue that the
IMF costs the US taxpayer nothing. The idea is that the IMF operates like a credit
union - we simply contribute funds and earn interest on these funds. Since the
interest rate we get on these IMF loans is comparable to the market rate, funds to the
IMF cost the US taxpayer nothing.
5.
The IMF imposes inappropriate policy prescriptions - A proponent would simply
admit that the IMF does the best it can. It is a very complicated and complex
macroeconomic world out there and we are still learning. If it weren’t for the IMF,
things would have been much worse.
Lessons of Currency Crisis - From Anatomy of a Currency Crisis - By Jane Little.
What are the lessons of this currency crisis? Two are well known but bear
repeating. A second pair may be more controversial.
1. Developing countries should adopt flexible exchange rate regimes as soon as
strains start to become evident. Markets can be extremely strict disciplinarians once
participants notice something amiss. Since investors tend to move in herds and
momentum traders abound, markets sometimes overshoot. Delay can thus result in
excessive devaluations, unwarranted output losses, and setbacks in the fight against
inflation that can take years to overcome.
2. LDCs must make their financial markets more transparent by providing more
data and by using generally accepted accounting standards -- of course. But data are
always subject to interpretation; thus, they are a necessary but not a sufficient condition
for avoiding future crises.
3. Multilateral rescue/reform packages must be multilateral and clearly
credible. The E. Asian turmoil was less well contained relative to the peso crisis of 199495. The Asian governments' resistance/inability to reform contributed enormously to this
outcome. But the West's hands-off attitude may also have played a role.
When the international community decides to provide a rescue package, it does so to
curb contagion, as lender of last resort. True, moral hazard is an important issue; the
international community should not encourage reckless future behavior by limiting
today's losses too quickly or too generously. But at some point, the need to stop
accumulating credit contraction takes precedence. In contrast to Mexico's $48 billion
package, which far exceeded that country's dollar-denominated Tesobono liabilities, the
$17 billion Thai rescue package was probably too small, given the central bank's $23
billion liability for dollars sold forward. In the end, a successful containment effort
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requires a financially and politically credible commitment from world policy makers -borrowers and lenders alike.
4. In future, policy makers may want to look more carefully at global asset prices
and the reasons for their behavior. Of late, policy makers worldwide have been well
satisfied with the benign trends in consumer prices. If asset prices seemed high, that was
a supervisory issue, not an issue for monetary policy. But with hindsight, the global asset
price inflation seen in Asian real estate prices and in equity prices elsewhere may have
been a significant symptom of excess world liquidity.
Brazil's President Cardoso described the currency crisis as "a ball that dropped on us
from Asia." He went on, "We are good at soccer, and we plan to send the ball back so it
falls on somebody else, or preferably in the middle of the Atlantic." We may all view the
crisis as a ball that dropped on us, but the crisis did not grow in a vacuum. These
problems reflect the many mistakes of individual developing nations and individual
investors. They also reflect the tight fiscal and relatively loose monetary policies of the
major industrialized countries. In times of crisis, policy makers usually feel compelled to
step forward to halt an asset-price collapse. Perhaps they also have a stake in curbing
excessive updrafts. The question is, how?
Asian Crisis Terms – make sure you know how these terms played a role in the Asian
crisis.
1. Chaebol
2. Crony Capitalism
3. Japanese Model
4. IMF
5. Moral Hazard
6. Excess Capacity – Glut
7. Capital Flight – capital inflows to US
8. Asian Monetary Fund
9. Exchange Stabilization Fund
10. Hubris
11. Credibility
12. Secrecy
13. Corruption
14. Transparency
15. Credit Agencies – Credit Ranking
16. Economies of Scale
17. Favoritism
18. Exclusivity
19. Unhedged Foreign Debt
20. Interest Rate Differential
21. Currency Pegs
22. Command and Control
23. Lax Banking Regulations
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24. Capital Controls
25. Below Market Interest Rates
26. Defending Currency
27. Trading ban/range
Practice Essay Questions
Essay Questions
1. Milton Friedman suggests that the IMF caused the Asian currency crisis. Explain.
2. Explain how the “Japanese Model” helped cause the problems in East Asia.
3. Explain why most of the East Asian countries were reluctant to bring in the IMF.
4. Some argue that if the Asian countries would have only let their currencies depreciate
earlier, the crisis may not have occurred. Explain.
5. Explain why East Asian banks and firms had such heavy debt with foreign,
international banks.
6. Explain how the Asian crisis affected the performance of the U.S. economy and
comment on the longer-term influence of the Asian crisis on the U.S. economy.
Russian Crisis Notes
As we shall see, the effects of the Russian crisis on the US economy are virtually
opposite as compared to the Asian crisis. The following three articles explain what
exactly happened and will get us started. We begin in the summer of 1998, roughly a
month before things got real bad. Enjoy the articles, we have lots to talk about!
July 13, 1998
IMF Tentatively Agrees on Plan
For Emergency Aid to Russia
By MATTHEW BRZEZINSKI and ANDREW HIGGINS
Staff Reporters of THE WALL STREET JOURNAL
U.S. officials said the International Monetary Fund has agreed to provide Russia with
an emergency-assistance package of $10 billion to $14 billion, and that the agreement
may be announced as early as Monday or Tuesday.
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The funds, the bulk of which will come from the IMF with a small amount from the
World Bank, will be disbursed within six months to two years, provided Russia
adopts a series of reforms outlined by Prime Minister Sergei Kiriyenko. His
“anticrisis” package aims to raise tax revenue, cut the country’s budget deficit and
increase competition in Russia’s economy. It will be put to a vote Wednesday in
Russia’s lower house, the Communist-dominated Duma.
U.S. officials said IMF and World Bank money wouldn’t start flowing to Russia until
there is a legal framework for the reforms, but they also said rejection of the reform
package by the Duma wouldn’t necessarily block the deal because President Boris
Yeltsin could enact most of the measures by decree. President Yeltsin has sometimes
resorted to decree to sidestep Russia’s often recalcitrant legislature.
The tentative agreement was reached after weeks of wrangling and was finalized in
talks Sunday between Mr. Kiriyenko and John Odling-Smee, an IMF official dealing
with Russia’s crisis. The agreement also followed appeals for help to President
Clinton and other world leaders by President Yeltsin. Russian officials said Sunday
that they had reached a deal with the IMF on “all key issues,” but didn’t provide any
details of the agreement.
Anatoly Chubais, Russia’s chief negotiator with the IMF, said in an interview last
week that Russia was also talking to Western commercial banks and hoped they
would grant loans equal to the final sum provided by the IMF. This could take the
total IMF-led package to between $20 billion and $28 billion.
A Western banker said Russia was in talks with syndicates for two loans totaling $10
billion. Half of this would go directly to the Finance Ministry; the Central Bank is
looking to establish a $5 billion credit line to be used only as a backup to fortify its
dwindling reserves. Russia’s foreign-currency reserves stood at $15.1 billion on July
3 but have fallen since then because the central bank has been buying rubles in an
effort to prop up the currency.
Nearly the entire IMF package will comprise new money for Russia, not an
acceleration of previously committed funds, U.S. officials said. The only exception,
they said, would be two payments by the IMF of $670 million each.
The new package doesn’t contain any funds from the U.S., officials said, but Japan is
negotiating to provide bilateral aid of about $600 million to Russia in co-financing
with the World Bank. Mr. Kiriyenko left Sunday for talks in Tokyo with Japanese
leaders.
Talks in Moscow with the IMF got a boost after President Yeltsin telephoned
President Clinton and the leaders of France, Britain, Japan and Germany to appeal for
assistance and promise that Russia would carry out its reform proposals. Treasury
Secretary Robert Rubin, on a visit to Africa, said Saturday that a strong and speedy
IMF program for Russia “is of critical importance.”
In an interview, Russia’s Finance Minister Mikhail Zadornov said Russia aimed to
increase tax collection by more than 25% by year-end. He said Russia urgently
needed IMF funds to win a “breathing space” and avoid a devaluation that could
cause havoc in the country’s ailing banking system.
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Russia is the latest country to be hammered by the financial turmoil that began in
Thailand last July. It follows Thailand, South Korea and Indonesia in seeking help
from international organizations. Adding to Russia’s woes is the drop in world oil
prices. Oil and gas are Russia’s principal exports.
Investors have been fleeing Russia since October when financial turmoil in Asia
triggered an exodus from emerging markets. Since then, Russia’s stock market has
lost two-thirds of its value.
“The prospect of a big IMF package is good news,” said Charles Blitzer, a former
World Bank economist in Moscow and an analyst at Donaldson, Lufkin and Jenrette
in London. “There seems to be a decision that the government is going to get space to
implement its reforms ... and not be driven to bankruptcy by market sentiment of the
moment.”
The capital flight has left Russia particularly exposed because the Kremlin has relied
greatly on foreign investors to finance the country’s budget deficits through highinterest-rate government-debt issues. Recently, Russia’s rickety domestic banks have
dumped ruble-denominated treasurys and borrowed rubles to buy dollars in
anticipation of a currency crash. Friday, the Standard & Poors rating agency
downgraded six leading Russian banks, warning the banking sector could be headed
for a liquidity crisis.
The Finance Minister, Mr. Zadornov, said Russia urgently needed IMF funds until
new tax revenue begins flowing in. He said Moscow currently spends $1 billion a
month servicing its foreign debt and $1 billion to $1.5 billion a week covering
redemptions of domestic treasurys.

Carla Anne Robbins in Washington contributed to this article.
Return to top of page | Format for printing Copyright © 1998 Dow Jones &
Company, Inc. All Rights Reserved.
September 22, 1998
Why a World-Wide Chain Reaction
Set Financial Markets Into a Spin
Once again, Russia is the Evil Empire.
By Michael Siconolfi, Anita Raghavan, Mitchell Pacelle and Michael R. Sesit of The
Wall Street Journal.
This time, it isn’t some ill-starred military adventure. Instead, the world is blaming
Russia for the chaos sweeping through financial markets over the past month. Russia’s
abrupt decision in mid-August to let the ruble’s value fall and default on part of its debt is
widely viewed as the reason for widespread selling in everything from Brazilian bonds to
U.S. stocks.
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But has Russia—which has an economy that accounts for less than 1% of the world’s
gross domestic product—even one spinning out of control— really wreaked billions of
dollars of market losses? Not by itself, it hasn’t.
What the virtual collapse of Russia’s markets did was touch off a global flight from
financial risk of all kinds. Russia’s actions were the trigger for that panicked flight, but
once started, it behaved like a chain reaction.
Big bets by sophisticated investors, many made with borrowed dollars and many having
nothing to do with Russia, suddenly went bad.
In a scramble to shore up their crumbling
finances and meet lenders’ demands for more collateral, those investors were forced to
sell out of other, safer investments. And as these investments in turn tumbled under the
selling pressure, the urge to flee became contagious, spreading quickly until it hammered
just about every financial instrument except super-safe U.S. Treasury securities and
German government bonds—which soared.
The result is that in the past five weeks, international investors have lost an estimated $95
billion on the stocks and bonds of so-called emerging markets, according to J.P. Morgan
& Co. Throughout, huge amounts of debt, built up over years to finance securities
purchases, have been unwound. Some victims have disclosed staggering losses.
Long-Term Capital Management, a fund for wealthy investors run by bond legend John
Meriwether, has lost $1.8 billion. Credit Suisse First Boston Corp. is out at least $400
million after tax, according to someone familiar with its situation. And Bankers Trust
Corp., a firm that had been trying for two years to lower its risk profile, has had its entire
third-quarter profit wiped out by losses totaling $350 million before taxes.
Even Merrill Lynch & Co., the most broadly diversified firm on Wall Street, has taken a
$135
million hit. And in many cases, securities firms’ losses are worse than disclosed because
they are using financial reserves to mask their full extent.
To be sure, the trading losses follow year upon year of lush profits by many of the same
firms now being punished for aggressively playing international markets. “What we’re
seeing is the dark side of a truly global marketplace,” says Merrill Lynch’s chairman,
David Komansky. “Going forward, this is what a global, wired economy will look like
during a market correction.”
While U.S. and European stocks have taken their lumps—the Dow Jones Industrial
Average is 15% below its peak in July—the losses in these markets are nothing like the
carnage in many others, including many kinds of bonds. When Mr. Komansky got home
one night, his wife asked him what the U.S. stock market did. His weary reply: “I have no
idea—I’ve been worried about the global bond markets.”
Much of the damage has been concentrated at securities firms and banks, and especially
hedge funds—investment pools for rich investors that often use arcane trading strategies
and borrowed money in a quest for outsize returns. Their holdings of Russian stocks and
bonds, needless to say, took a beating. But interviews with scores of Wall Street
executives, traders and bankers show that some of the biggest hedge funds, as well as
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many securities firms in the U.S., Europe and Japan, made three major bets unrelated to
Russia that have gone disastrously awry:
In a bid to take advantage of tiny price discrepancies among types of bonds, Long-Term
Capital and many other firms borrowed to finance big purchases of riskier bonds while
betting that U.S. government securities’ prices would fall.
Hedge funds, among them Julian Robertson’s Tiger Management, made big wagers that
while Japan struggled vainly with its worsening economic malaise, investors would
continue to sell the Japanese yen and buy American dollars.
Securities firms, chief among them Travelers Group’s Salomon Smith Barney, made
billion-dollar bets that as European monetary union approached, differences in the yields
of various government bonds would narrow.
Indeed, no firm has been more emblematic of the global scope of the losses than Salomon
Smith Barney. Even though co-chairman Jamie Dimon had ordered its traders to liquidate
their positions in Russia in July, weeks before Moscow defaulted, Salomon has suffered
after-tax losses totaling $360 million.
Just $10 million of that stemmed directly from investments in Russia. A further $50
million was from lending to a hedge fund that invested in Russia and went bust. The rest
came from bond-market bets that had little or nothing to do with Russia but went bad
anyway, as investors’ headlong rush for safety confounded expectations of the way
various kinds of bonds would behave.
“Russia was the match, but the markets were ripe for dislocation,” Mr. Dimon says.
And they haven’t settled down yet. The scramble to unload almost any kind of risky
investment has been so urgent that some markets, particularly for riskier bonds, are
paralyzed, leaving firms holding far more of them than they want. The firms’ continuing
efforts to cut their holdings suggest more declines ahead.
Beyond that are fears that other nations will follow Russia’s lead. Already, Malaysia has
applied rigid controls that limit foreign investors’ ability to get their money out. Stock
markets around the world remain volatile as investors worry about a crisis of confidence
erupting in another developing nation.
“It’s not like in ‘87 when the market plunged and by 6 p.m. you knew what your losses
were,” says Max Chapman Jr., chairman of Nomura Securities Co.’s three regional units
outside Japan. “This one is more insidious. It is getting you from all places. If you’re a
global player, you get kind of dizzy.”
Until this summer, Russia made some sense as a place to invest. The Asian turmoil that
began with a mid-1997 devaluation of the Thai baht hadn’t reached Moscow. Yields on
Russia’s government debt were high. Major firms such as Goldman, Sachs & Co. and
Chase Manhattan Corp. were competing to underwrite government bonds and lead
syndicated loans to Russian companies, while hedge-fund investors such as George Soros
and Leon Cooperman were there, too. With such stars paving the way, other investors felt
comfortable in the Russian market. Some Wall Street traders bought Russian bonds for
their personal accounts.
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“Interest rates were so high it was almost as if they were giving money away,” says Dana
McGinnis, a San Antonio manager of three emerging-market hedge funds. His McGinnis
Advisors invested a large chunk of its $200 million in Russia.
Then in August, Russian political and economic conditions, which had been slowly
worsening, began to disintegrate. Investors increasingly anticipated a ruble devaluation.
Yet some, such as Mr. McGinnis, weren’t worried. They thought they had purchased
protection: the right to convert rubles into dollars at fixed rates, through contracts they
had made with Western and Russian banks.
Marc Hotimsky, global-bond chief for Credit Suisse First Boston, met with officials in
Moscow and was assured that Russia would meet its obligations and wanted a stable
ruble. Leaving the country on Friday, Aug. 14, he says, he “had a sense the situation in
Russia was critical, but I didn’t think they would default.”
On Monday, they did. Although Russia didn’t tamper with the government’s foreigncurrency debt, it announced it would restructure its treasury bills and impose a
moratorium on repayment of $40 billion in corporate and bank debt to foreign creditors.
It said it would let the ruble’s value against the dollar fall by up to 34%. (The ruble didn’t
stop where it was supposed to, as devalued currencies often don’t.)
Wake-Up Call
The news came as a jolt to Rodolfo Amoresano. As chief of emerging-markets
proprietary trading for Nomura’s New York unit, he was sitting on a $200 million
position in Russian treasury bills, traders other than Mr. Amoresano say, after returning
from Russia with assurances that the government wanted a stable ruble. Awakened at 3
a.m. by the news, he dashed to the office to warn others of the danger, the traders say.
Then he boarded a plane back to Russia to try to sort out the mess.
The bills were supposedly protected by forward currency contracts entered into with big
Russian banks. But Russia’s debt moratorium apparently allows its banks to ignore their
forward-contract obligations for 90 days; terms of the freeze are so confused that parties
are still haggling over what they mean.
Those holding Russian securities were stuck. There was no trading. No bids, no offers. A
trading strategy that had been profitable—Nomura’s New York unit had made a total of
about $100 million in Russia in the prior three years, the traders say—suddenly was
destroyed. Nomura ended up with Russia-related pretax losses totaling $350 million,
including $125 million in Mr. Amoresano’s “book.” (The rest came from the London
operation.) A Nomura spokesman declines to comment.
Investors in Russian securities weren’t the only ones affected; so were those who had lent
to such investors. Creditors of hedge funds, convinced the funds wouldn’t get back all the
money they had put into Russia, issued demands for more collateral, known as margin
calls.
The funds had to raise capital to meet the calls, but they couldn’t do so by selling Russian
securities, with those markets paralyzed. So they began selling other assets, including
U.S. stocks.
One who got a margin call was Mr. McGinnis in San Antonio. His funds had $100
million of Russian bonds, bought with leverage; he, too, found that his currency contracts
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didn’t protect him when Russia defaulted. He says Citicorp, First Boston and Lehman
Brothers Holdings Inc. demanded more collateral. To raise it, he says, he began dumping
“everything else.”
It wasn’t enough. In late August, Mr. McGinnis’s funds sought Chapter 11 bankruptcy
protection in San Antonio federal court.
Talk spread that Russian treasury bills might be worth only 10 cents on the dollar. “The
second you hear that, you’re feeling, ‘I don’t want to hold any other similar emergingmarket debt,’ “ says Philipp Hildebrand, a strategist for the British affiliate of Moore
Capital Management, a New York hedge fund. “You had an immediate and substantial
collapse in risk appetite.” Holders began selling bonds from South Korea, Greece,
Turkey, Mexico, Brazil.
Some Who’ve Taken Big Hits
Institution Damage
Bank America
$330 million pretax trading losses
Bankers Trust
$350 million trading losses in July, August
Republic New York
Russia-related charges of $155 million
Salomon Smith Barney
$360 million in after-tax trading and Russia-related credit losses
Nomura Securities
$350 million in pretax Russia-related losses
Credit Suisse First Boston
$400 million in after-tax Russia-related losses
Long-Term Capital Hedge fund down 44% in August
III Offshore Advisors
One hedge fund filed for liquidation
Sources: J.P. Morgan, Telerate
But buyers for what they wanted to sell were rapidly disappearing. “If you didn’t sell by
Aug. 25, you were probably stuck in the mud,” says Peter Marber, president of
Wasserstein Perella Group Inc.’s asset-management unit, whose two hedge funds
incurred big August losses. From the Friday before Russia devalued until 10 days
afterward, the J.P. Morgan Emerging Market Bond Index fell nearly 25%.
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Trimmed Hedges
One hedge fund, III Offshore Advisors’ High Risk Opportunities Hub Fund, faced margin
calls from lenders such as Salomon Smith Barney, First Boston, Lehman and Bankers
Trust, according to a person familiar with the matter. To raise the money, the fund sought
to collect on forward currency contracts it had signed with Deutsche Bank AG, Credit
Lyonnais, Societe Generale Group and the ING Barings unit of ING Group. Although
those contracts hadn’t yet come due, III Offshore partner Warren Mosler says the hedgefund firm was entitled to demand some payment—he puts it at $300 million—based on
the contracts’ present value. But the European banks wouldn’t pay, he says, and III
Offshore, which is based in West Palm Beach, Fla., had to file to liquidate the hedge
fund. The banks “defaulted,” Mr. Mosler asserts. “What brought down the fund is these
guys failed to meet their obligations.”
Credit Lyonnais and Societe Generale decline to comment. A spokeswoman for ING says
it is unaware of any dispute. Deutsche Bank says it “complied with all contractual
obligations.” Even if a firm was prescient, it wasn’t easy to move quickly enough. In
July, Mr. Dimon hammered home his concerns over Russia and Indonesia to Salomon
Smith Barney’s risk-management committee. “I want out,” Mr. Dimon said, according to
some who were there.
The traders were resistant. Indonesia had already taken its licks, and prospects for an
IMF-led credit made Russia’s situation appear calmer. But the traders went to work,
whittling down Russian-bond positions of more than $100 million. Salomon’s
repurchase-agreement desk, which does overnight financing for institutions such as hedge
funds, also started to reduce its exposure to funds investing in Russia. But the effort
wasn’t rigorous enough. Salomon got stung by a loan of nearly $50 million it made to the
III Offshore Advisors fund that is being liquidated. Mr. Dimon declines to comment.
Bonds Diverge
Now, as investors rushed for the sanctuary of U.S. Treasurys, the value of those bonds
began to soar. Monday the 30-year bond’s yield got as low as 5.05% before late trading
pushed it back up to a still-ultralow 5.124%. But the same thirst for safety caused
investors to flee from riskier bonds, including those of emerging markets, U.S. mortgagebacked securities, high-yield “junk” bonds and even investment-grade corporate bonds.
“The whole world was on one side of the ship for three years, and now they wanted
to go to the other side of the ship all at once,” says Greg Hopper, a portfolio
manager at Bankers Trust Global Investment Management.
The shift wreaked havoc with some of the most complex and leveraged market bets made
prior to the Russian turmoil. Among them were bets on the spreads between the yields on
various kinds of bonds. Many hedge funds and investment banks had wagered that
growing demand for riskier bonds around the world would cause these bonds’
prices to rise and their yields to fall, but that yields would rise on the safest
government bonds. The flight to safety caused the reverse to happen.
At Long-Term Capital’s plush headquarters in Greenwich, Conn., traders watched in
horror as one after another of the firm’s bets exploded. Traders were left to follow “the
action on the screens and marvel at the violence out there in the marketplace,” a person
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familiar with the operation says. “When you have a global movement, all the trades go
against you at the same time.”
Declines in the hedge fund’s net worth triggered internal controls requiring that risk be
reduced. So it started dumping some securities and unwinding interest-rate bets. Through
it all, the firm was being peppered with calls from Lehman and Salomon Smith Barney,
two of its lenders, for information about trades and the extent of losses.
Rumors spread that Long-Term Capital was in trouble. They intensified after the New
York Stock Exchange, as part of a broader Wall Street sweep, quizzed securities houses
about whether Long-Term Capital was meeting its margin calls. It was.
Grim News
But on Sept. 2, Mr. Meriwether, who once was Salomon Brothers’ vice chairman, broke
the news to the hedge fund’s investors: Its value had plunged 44% in August. The total
loss was $1.8 billion. Yet, in a measure of how far the ripples had spread beyond
Moscow, only 8.7% of the losses came in Russian markets, says a person familiar with
the results.
Nor was Merrill Lynch spared. In the wholesale flight to safety, even U.S. corporate
bonds got slammed, and Merrill Lynch, as a leading underwriter and market maker,
owned a $5 billion portfolio of them. Making matters worse was that one way Merrill had
tried to protect itself from such a decline was by selling U.S. Treasurys short, figuring
that if corporate bonds fell, so would Treasurys; when they soared, this bet only worsened
Merrill’s losses.
Merrill’s bond-related losses exceeded $100 million, pretax, traders say. Although the
firm has said it had after-tax emerging-markets losses in July and August of $135 million,
it won’t provide a breakdown.
A broader concern in the bond market has been gridlock. In recent weeks, buyers
have simply shunned a broad range of bonds, from U.S. junk bonds to any
emerging-market debt. Some emerging-market bonds have vast spreads between the bid
price and the offer, making it all but impossible to trade. Last week, recalls Andrew
Brenner, a bond trader at Societe Generale, the bid-offer spread on a bond from a
Brazilian state water utility known as Sabesp was 15 points-you could sell it at 70 and
buy it at 85. “Obviously, I couldn’t get anything done,” Mr. Brenner says.
Indeed, not much of anything is going on in broad parts of the bond market—even on
days when the stock market rallies. On Sept. 8, as U.S. stocks were soaring on a bout of
investor optimism, Donaldson, Lufkin & Jenrette Inc. executive David DeLucia received
word from his top traders that buyers were nowhere to be found in much of the high-yield
market. “There’s still decent demand for high-quality names, but liquidity seems to dry
up for names beneath that,” Mr. DeLucia says.
Merrill owned Brazilian corporate bonds that it had hedged by taking short positions in
Brazilian government bonds—that is, it had bet on a decline in the government bonds’
price by selling them without owning them. The minute bids for the bonds appeared on
traders’ screens, they were snapped up. “Any buying was quickly satisfied,” Mr.
Komansky says. “You couldn’t cover your shorts. You couldn’t sell your longs.”
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All the recent turmoil in the bond market has hammered home a lesson in protecting
one’s assets. Quips Mr. Komansky: “The only perfect hedge is when someone else owns
it.”
Masking Losses
Even when firms have disclosed their global market losses, these amounts often are
severely understated. This is because many major brokerage firms have been tapping into
reserves they had accumulated during the big bull market to mask the full extent of their
recent trading deficits. Though Lehman Brothers, for example, recently announced an
after-tax loss of $60 million from emerging-markets woes, Wall Street traders say the
firm actually had total pretax losses of about $200 million. Lehman declines to comment
on its use of reserves.
Traders say Lehman’s losses also were tempered by separate winning trades, including
selling emerging-market stocks (which have plunged) and purchasing U.S. government
bonds (which have soared). “We lost some money in hedging some securities positions,
but offsetting that we were long governments in a big way,” says Richard Fuld, Lehman’s
chairman. “We had a view that during time of turmoil there would be a flight to quality.”
All that didn’t stop some rumors from becoming entrenched. Lehman’s already-battered
stock was slammed an added 7% on Sept. 11 amid speculation the firm would file for
bankruptcy protection. Senior officials scrambled to assure clients Lehman was secure.
But so prevalent were the rumors that the New York Stock Exchange examined
Lehman’s books. Big Board Chairman Richard Grasso personally called Mr. Fuld later
in the day to tell him the firm had passed the review. Monday, Moody’s Investors Service
confirmed Lehman’s debt ratings and said the firm’s ratings outlook is “stable.”
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Europe’s Yields
Across the Atlantic, another problem was festering. Costas Kaplanis, head of Salomon
Smith Barney’s global-arbitrage trading group in London, had made good money over
two years betting that the differences in yields on various European bonds would narrow
as European monetary union neared. Among its billion-dollar trading positions, say
people familiar with the situation, was a bet on a convergence in the yields of
German and Italian bonds.
But in the flight to quality set off by the Russian crisis, the yields started diverging,
because German bonds were regarded as safer than Italian bonds. Executives in
New York ordered Mr. Kaplanis to unwind some of the bets and reduce others. The
paralysis gripping bond markets hampered the effort, and the global-arbitrage group
wound up with $180 million in after-tax trading losses.
More losses arose in Salomon Smith Barney’s U.S. arbitrage group. Its traders had placed
$1 billion bets on the London Interbank Offered Rate, or Libor, on the expectation that
the spread between that rate and U.S. Treasury yields would narrow. Instead, it
ballooned, leading to after-tax losses of $120 million.
At New York headquarters, Salomon Smith Barney’s senior executives roamed the
trading floors telling their traders not to be heroes by taking on risky positions that clients
were trying to shed. They were urged to bid for securities 10% to 15% below the last
trade, rather than the usual 2%, 3% or 4%. Clients asking the firm to bid on a million
shares of stock were rebuffed or got steeply discounted bids. More frequently, traders
told clients they would bid for much smaller blocks and try to parcel out the rest of the
order.
Yen Bet Goes Bad
Steven Black, a Salomon Smith Barney vice chairman, told his troops to balance their
priorities: “We can’t trade just for the benefit of clients if it would be irresponsible to the
firm’s position or to shareholders. Anything we do should be prudent.”
The U.S. dollar, like U.S. Treasury securities, is a haven for worried investors, but the
market has been so topsy-turvy that even some bets on a stronger dollar went sour. With
Japanese interest rates extremely low, hedge funds and others had borrowed huge
amounts of Japanese yen and sold them in order to buy the higher-yielding
securities of other countries. This meant, of course, that eventually the funds would
have to buy yen to repay the loans.
In late August, a Japanese official said Tokyo was close to intervening to support the
yen. Meanwhile, plunging U.S. stocks raised fear of a weaker dollar vis-a-vis the
yen. Hedge funds abruptly began buying yen to cover their borrowings.
That further strengthened the yen. Mr. Robertson’s $21 billion Tiger Management
Fund, one of the biggest bettors against the yen, lost 10%, or $2.1 billion, in the first
two weeks of September.
What’s With Stocks?
Through it all, individual investors in many markets, including the U.S. stocks, were
mystified. For the first time since the 1987 crash, falling prices weren’t drawing large
sums from people intent on “buying the dip.” Nor were falling interest rates. Twice in the
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month following Russia’s devaluation, the Dow Industrials slipped close to 20% below
their July high, the level loosely regarded as marking a bear market. In one stretch, the
Dow Industrials moved up or down at least 100 points in 10 of 12 trading sessions.
Exchange officials grew worried that two “specialist” firms, which buy and sell to meet
demand and smooth out trading, would be in danger if the market continued to falter. Big
Board officials met with principals of the firms, paving the way for one to get a capital
injection from its partners and the other to be absorbed by rival firm.
In contrast to 1987, however, the systems underpinning the U.S. stock market haven’t
cracked. Trading has been relatively orderly, nothing like the violent selling seen on Oct.
19, 1987.
On Aug. 31, as the market spiraled toward what became a 512-point, 6.37% plunge, Mr.
Grasso—who has been a Big Board executive for more than a decade—sought a reading
from Edward McMahon, Merrill Lynch’s chief of trading in exchange-listed stocks. Mr.
McMahon had a simple but clear message: “No shouting. Bids wanted.”
Translation: Traders were filling orders without panic—a far cry from the frantic message
he heard in 1987.

Matt Murray contributed to this article.
Return to top of page | Format for printing Copyright © 1998 Dow Jones & Company, Inc. All
Rights Reserved.
November 17, 1998
How the Fed Fumbled and Then
Recovered in Making Policy Shift
By DAVID WESSEL
Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON—Shortly after the Federal Reserve announced early in the afternoon on
Sept. 29 that it was cutting interest rates, top Fed officials realized they had made a
mistake.
They had hoped their first rate cut in nearly three years would reassure financial markets
that the world’s most powerful central bank was prepared to do what was needed to avoid
a global economic meltdown.
But Fed Chairman Alan Greenspan, known for often-obscure pronouncements, had
sounded a clear alert that a rate cut was imminent, and the markets shrugged when the
Fed trimmed just a quarter percentage point off its key short-term interest rate.
Edward Boehne, president of the Philadelphia Federal Reserve Bank, says he knew a few
days later that the Fed had goofed. When he checked into a hotel in a small town in
Pennsylvania, the clerk looked at his title and said, “You didn’t do enough.”
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“You don’t usually get that from a hotel clerk,” Mr. Boehne says.
Inside the Fed, the next two weeks were filled with introspection and second-guessing of
Mr. Greenspan’s go-slow proclivities.
The handful of Fed policy makers who had argued for a more dramatic half-percentagepoint rate cut felt vindicated. Officials at the Federal Reserve Bank of New York worried
that the rate cut had done little to reverse a stampede away from risky, and even not-sorisky, bonds.
Something More
Quietly, but forcefully, New York Fed President William McDonough, 64, who sees
himself as a potential successor to the 72-year-old Mr. Greenspan, and Alice Rivlin, the
former White House budget director who is vice chairman of the Fed, pushed for
something more.
That “something more” turned out to be a surprise quarter-percentage-point cut in rates
on Oct. 15, a moment that Mr. Greenspan chose because he sensed that financial markets
were ready to respond favorably.
The Fed knew the move would grab attention: It was first time since 1994 that the central
bank had changed interest rates between scheduled policy-committee meetings. But
would it provide a jolt of confidence to the markets? Or would it be seen as evidence that
the Fed’s take on the financial crisis was bleaker than everyone else’s?
To the Fed’s relief, it turned out to be the former. Markets rallied instantly, and have
hardly looked back.
Indeed, as Fed officials prepare to sit down Tuesday around their two-ton mahogany-andgranite conference table to ponder another rate cut, prospects for the U.S. economy look
rosier than they did a month ago—so much better that some Wall Street analysts who
were confidently predicting the Fed would reduce rates again now aren’t so sure.
Promising Signals
The economy seems to be growing at a better-than-expected pace of nearly 3% in the
second half of 1998. The stock market is ebullient, causing a few at the Fed to begin
worrying again about “irrational exuberance,” and prompting some to raise forecasts for
consumer spending next year. Global markets are calmer.
Nonetheless, the Fed’s internal forecasts indicate the economy will slow substantially in
the first half of 1999, putting the nearly eight-year-long U.S. expansion at risk. The bond
market is still showing signs of stress and lack of liquidity. And Fed officials know that if
they are to give any boost to next year’s economy, they must move soon. But whether or
not a rate cut comes Tuesday, the widespread expectation is for further cuts in the months
ahead.
For an institution that rarely changes direction quickly, this is a remarkably rapid aboutface. After all, the Fed came very close to raising interest rates this past spring because it
feared the unexpected vitality of the U.S. economy would lead to inflation.
The policy change reflects the deterioration of the global outlook following Russia’s
default on its debts in August. But the Fed hasn’t always reacted rapidly to changes in the
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financial environment. Indeed, at times, it has prided itself on not being swayed by Wall
Street phobias of the moment.
For several reasons, this time was different:
The current crop of Fed policy makers is more pragmatic than in the past. Those who
adhere to a particular school of thought—tracking the money supply or comparing
today’s jobless rate to the rate at which inflation has taken off in the past—have been
trumped by the fact that inflation hasn’t taken off as they anticipated. Inflation has been
falling even though unemployment is at a quarter-century low. To predictions from Fed
colleagues that inflation is around the corner, Mr. Greenspan has replied simply: Show
me evidence. There hasn’t been much.
Influential Fed officials, including Mr. Greenspan, saw this as a time when prudent policy
meant looking beyond conventional gauges. It meant asking questions like: With Japan in
political paralysis and Europe preoccupied with monetary union, what can the U.S.
central bank do to avert a global financial catastrophe? The Fed rarely faces such
questions, but when it does, the consequences of error are huge: witness the Great
Depression.
Mr. Greenspan, who dominates the institution he has run since 1987, saw a threat to what
he calls the best economy in 50 years. Credibility is hard to measure, but Mr. Greenspan
has lots of it. When he resisted pressure to raise rates, the markets didn’t assault him as
soft on inflation, and his uneasy colleagues didn’t revolt. When he decided it was time to
cut rates, the rest of the Fed followed.
Although the Fed chief cultivates consensus, there is no doubt who calls the shots. At
meetings of the Fed’s policy-setting Federal Open Market Committee, Mr. Greenspan
listens as each official gives his or her views on the economy. But when it is time to
decide what to do about interest rates, Mr. Greenspan speaks first. Anyone advocating a
different policy has to make a deliberate decision to differ with him.
A majority on the FOMC had been eager to raise rates early in the fall of 1997, before the
virulence of the Asian flu was evident. That September, Mr. Greenspan held them off,
arguing that he hadn’t prepared the markets. When the committee reconvened in October
and November, intensifying economic woes in Asia made raising rates nearly impossible.
When the FOMC met at the end of March, the Asian financial crisis appeared to be in
remission. The long-predicted slowdown in the U.S. economy had failed to arrive. The
ghost of inflation was lurking, even if there were few signs that wages or prices were
going up more rapidly.
“There was a sense that maybe the Asian drag wasn’t going to be as great as anticipated,”
Alfred Broaddus, president of the Richmond, Va., Federal Reserve Bank, recalled in an
interview during the summer.
Signing On
Again, Mr. Greenspan, who doubted that the wage increases feared by some Fed officials
would actually materialize, talked his colleagues out of raising rates. But he joined the
consensus that a rate increase was “a likely prospect in the not too distant future,”
according to a published summary of the session. The question wasn’t if, but when. With
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unemployment at a low 4.6% and the pace of money-supply growth quickening, there
was no thought given to cutting rates.
By July, a rate increase no longer seemed a certainty-at least to Mr. Greenspan. Although
the FOMC was still formally leaning in favor of higher rates in the written statement it
crafts at the end of each meeting, the chairman signaled in congressional testimony in late
July that he wasn’t. By the Fed’s August meeting, which came just a day after Russia’s
default, it was clear that weakening exports and mounting inventories were squeezing
American manufacturers. Few Fed officials still were thinking about higher rates, but
most weren’t ready to lower them.
Each year at the end of August, Mr. Greenspan and other top Fed officials attend the
Federal Reserve Bank of Kansas City’s conference at Jackson Hole, Wyo., in the majestic
Tetons. This year’s topic was inequality, but the only subject of coffee-break, hiking-trail
and golf-course conversation was what to do about the spreading global financial crisis.
Private economists, eager to be quoted, sought out reporters to argue for cutting rates.
Fed officials, just as eager not to be quoted, pooh-poohed those arguments.
But the important conversations were taking place in the quiet huddles in and around the
Jackson Lake Lodge among the five Fed governors, seven Fed bank presidents and top
Fed and foreign central-bank staffers who were there. The market reaction to Russia’s
default was severe and unexpected. The daily reports that the New York Fed prepared for
officials showed a worrisome, widening gap between the yield on corporate bonds and
government bonds, a rare occurrence except when the economy is in recession. In the
market for supersafe U.S. Treasury bonds, there was an unusually strong preference for
the most easily traded issues, which the Fed read as a sign of unhealthy anxiety.
Speaking Up
It was, the Fed officials agreed, time for them to say something to the world.
Mr. Greenspan stuck to his plan to spend a week at a tennis camp, though he got so many
phone calls about the plunging stock market that he jokes that he kept a tennis racket in
one hand and a cellular phone in the other. But a speech planned for the University of
California at Berkeley’s business school on Friday, Sept. 4, offered a convenient
opportunity.
Clearing key passages in advance with each member of the FOMC, Mr. Greenspan
declared that the U.S. couldn’t hope to remain an “oasis of prosperity.” As flatly as he
ever says anything, he said the Fed no longer was leaning toward raising rates.
A week later, a statement from the world’s leading central bankers and finance ministers
led to speculation that the central banks would cut rates in concert. But Mr. Greenspan
and his peers don’t like anyone thinking they subordinate national priorities to global
ones—even if they sometimes do. Mr. Greenspan’s German counterpart, Hans
Tietmeyer, quickly quashed the notion that he was coordinating anything with anyone.
Mr. Greenspan did the same, telling Congress on Sept. 16, “At the moment, there is no
endeavor to coordinate interest-rate cuts.” He said other things, too, but that was all the
markets heard.
In the days that followed, bond-market investors grew even more skittish, making it
difficult for many firms to borrow. Caught off-guard, Long-Term Capital Management
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LP, the huge hedge fund, came crawling to the New York Fed, saying it needed capital
and was having trouble raising it. If LTCM’s holdings were dumped on the bond market
all at once, New York Fed President McDonough told Mr. Greenspan, the odds of
calamity were uncomfortably high. On Sept. 20, New York Fed officials got a look at
Long-Term Capital’s books. They were shocked.
While Mr. McDonough and his staff tried to organize a Wall Street rescue of Long-Term
Capital, Mr. Greenspan focused on how perplexed the markets were about the Fed’s
inclinations.
To keep other Fed officials happy, Mr. Greenspan makes major policy changes only at
FOMC meetings—partly so the Fed doesn’t look like the one-man show it often is. But
the FOMC wasn’t set to meet until Sept. 29. He didn’t want to wait. He accepted a
standing invitation to testify before the Senate Budget Committee. On Sept. 21, even
though some Fed officials were unavailable because it was the Jewish New Year, he
convened a conference call to be sure his colleagues were also ready to cut rates.
They were. On Capitol Hill, Mr. Greenspan essentially announced the Fed was about to
act. “We know where we have to go,” he said. The stock market cheered, even though it
would be six days until the Fed actually lowered to 5 ¼ % its target for the federal-funds
rate, the interest rate at which banks lend to one another.
‘Irrelevant’ Amount
The argument for initially cutting rates by only a quarter point prevailed because most
Fed officials figured that simply changing direction would make a big enough splash. “I
thought the amount was irrelevant,” says Mr. Boehne, the Philadelphia Fed president.
“The problem with 50 basis points”-jargon for a half percentage point-“was that people
could have inferred that we knew more bad things than we did.” Mr. Greenspan made the
same argument internally.
But after the Fed’s Sept. 29 announcement, the stock market sagged, and the worrisome
spreads in the bond market widened.
A week later, Mr. Greenspan delivered a rambling, off-the-cuff early morning speech to
the National Association for Business Economics. He had two goals. The first was to
dispel the sense of doom and gloom that had descended. Officials from emerging-market
economies who had come to Washington for the annual meetings of the International
Monetary Fund and the World Bank had talked as if the era of capitalism were over. The
press was filled with what he considered overblown talk of a wrenching credit crunch.
The second goal, somewhat at odds with the first, was to lay the foundation for another
rate cut by detailing the evidence that uncertainty and fear were causing investors to, as
he put it, “disengage.”
But when to cut? Fed officials couldn’t afford another tactical error or muddled message.
They didn’t want anyone to think they were responding to a particular economic
indicator, to a down day in the stock market or to rumors that a big bank was about to
collapse.
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Time for Action
By Thursday, Oct. 15, Mr. Greenspan figured the spreads in the bond market he had been
tracking had grown so wide that they were bound to begin to narrow soon. It was time.
He convened a telephone conference call of the FOMC.
Participants say the hour-long conversation was unusual. Breaking from past practice,
Mr. Greenspan let each Fed governor and bank president speak before stating his
druthers, an effort to bolster the sense that he was seeking a consensus. When he
disclosed his plans, no one objected strenuously—and he didn’t ask for a vote.
The move was a success (except for an embarrassing typo in the 3:14 p.m. news release,
in which the Fed misstated the details of the rate cut). Stocks and bonds leapt. One
measure Mr. Greenspan has been tracking closely— the difference between yields on
more-easily traded and less-easily traded Treasurys—improved.
On their TV sets and computer screens, Fed officials watched the instant analysis with a
bit of trepidation. But the reaction was almost universally favorable, and the intended
message was received: The Fed was prepared to do what was necessary. “Yes!” one Fed
governor said late that afternoon after listening to a Wall Street pundit on CNBC, the
business cable channel. “They got it right.”
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Inc. All Rights Reserved.
132
November 17, 1998
Fed Trims Short-Term Interest Rates,
Marking Third Cut in Seven Weeks
An INTERACTIVE JOURNAL News Roundup
Citing “unusual strains” on financial markets, Federal Reserve policy makers cut interest
rates Tuesday, moving for the third time in seven weeks to keep the U.S. economy from
slipping into a recession.
The Fed announced that it trimmed its target for the federal-funds rate by one-quarter of a
percentage point to 4.75%. It was the third one-quarter-point slice off the rate, at which
banks lend to each other overnight, since Sept. 29.
“Although conditions in financial markets have settled down materially since midOctober, unusual strains remain,” central bank policy makers said. The sentence echoed
earlier statements by Fed Chairman Alan Greenspan expressing concern over evidence
that investors increasingly were putting their money into government bonds rather than
similar corporate paper.
The typically brief statement lacked elaboration but nevertheless appeared to signal the
Fed doesn’t expect to cut rates again soon. In an unusual look forward, the Federal Open
Market Committee said that it expects that its combined three-quarter point cut since
September “to be consistent with fostering sustained economic expansion while keeping
inflationary pressures subdued.”
“Expectations for further cuts have been reduced substantially,” said Ken Fan, market
strategist at Paribas Capital Markets in New York.
The FOMC—which includes the six Fed governors (there is one vacancy) and five of the
Fed’s regional-bank presidents—also cut the discount rate by one-quarter point to 4.5%.
That move in the rate, which the Fed charges depositary institutions, was made in
response to requests from the Fed banks in New York, Philadelphia and Dallas.
Stocks climbed out of negative territory after the Fed move, which was announced about
2:20 p.m. EST. The Dow Jones Industrial Average ended the day with a small loss, but
other indicators finished with gains. Bond prices had largely already factored in the cut
and drifted lower after the announcement.
Although the Fed’s move has no direct effect on consumers, by reducing the cost of
money to banks, it effects trickle down pretty quickly. BankAmerica Corp. and Chase
Manhattan Corp., for example, immediately responded by cutting their prime lending
rates a quarter point to 7.75%. The prime serves as a benchmark for a variety of
consumer and business loans, from credit cards to auto loans.
Tuesday’s move was widely expected, but with economic data reflecting surprising vigor
in recent weeks, there were some economists who considered the Fed’s move a toss-up.
133
The Fed’s own manufacturing index, for example, rose 0.3% in October. Meanwhile,
consumer spending is motoring along and the unemployment rate is humming at a low
4.6%.
Also, Mr. Greenspan earlier this month said that one concern that had spurred the earlier
interest-rate cuts—increased investor anxiety—was easing.
But some of that renewed confidence, visible in the industrial average closing above 9000
on Monday for the first time in three months, was fueled by expectations that the Fed
would reduce rates again. Indeed, traders said in advance of the Fed move that if the
central bank didn’t cut rates, stocks could easily drop 200 points. Put another way, the
Fed had to make the cut as much to avoid a negative outcome as to promote a positive
one.
“If you’re going to make a mistake at this point, better to ease when it’s not necessary,”
said Dana Saporta, an economist with Stone & McCarthy Research Associates.
And while the economy appears to be growing at a better-than-expected pace of nearly
3% for the second half of this year, the Fed’s internal forecasts indicate the economy will
slow substantially in the first half of 1999, putting the nearly eight-year-long U.S.
expansion at risk.
The Fed, meanwhile, had a fair amount of room to stimulate spending without spurring
inflation. The government reported Tuesday morning, for example, that inflation at the
consumer level is running at just 1.5% for the last 12 months. By comparison, last year’s
inflation rate of 1.7% was the lowest it had been in 11 years.
There was also the global picture to consider. While the Fed is loathe to give the
impression that international interests are taking precedence over domestic ones, action
by the U.S. central bank can calm overseas investors who are jittery about emerging
markets.
Some economists said another cut by the Federal Reserve would provide an impetus for
other nations around the globe to do the same.
“Given the current benign inflationary outlook, there is plenty of leeway for them to
lead,” Stephen Roach, Morgan Stanley Dean Witter’s chief economist, told the CNBC
cable network Tuesday morning.
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134
The Following graphs depict the behavior of some major financial variables during the
Credit Crunch of 1998. Source for all graphs; Federal Reserve Board of Governors
U.S. Three Month T-bill
5.50
TCM3M
5.25
5.00
4.75
4.50
4.25
4.00
3.75
3.50
J
F
M
A
M
J J
1997
A
S
O
N
D
J
F
M
A
M
J J
1998
A
S
O
N
D
J
Figure 1
Figure 1 depicts the rally in the 3 month T-bill market that Russia set off in August of
1998.
135
U.S. Three Month T-bill
5.25
5.00
4.75
4.50
4.25
4.00
3.75
3.50
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
1998
Figure 2
The first vertical bar is the announcement of the debt moratorium. The following three
vertical bars are the three cuts by the FOMC. Note the rally in the T-bill market began
right after the Russian crisis.
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Corporate Bonds: AAA, BAA and T-bills
7.5
BAA
7.0
6.5
AAA
6.0
5.5
5.0
TBill
4.5
4.0
3.5
Jun
Jul
1998
Aug
Sep
Oct
Nov
Dec
Jan
Figure 3
Why is the interest rate on BAA higher than AAA ? Why are both corporate yields
higher than the T-bill?
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Interest Rate Spreads: AAA minus T-bill ; BAA minus T-bill
3.60
3.20
2.80
2.40
BAA - TBill
2.00
1.60
AAA - TBill
1.20
Jun
Jul
1998
Aug
Sep
Oct
Nov
Dec
Jan
Figure 4
Note how effective the surprise interest rate cut by the Fed was in lowering the spreads.
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Spread: 90 day non-financial commercial paper minus T-bill
2.00
1.75
1.50
1.25
1.00
0.75
0.50
Jun
Jul
1998
Aug
Sep
Oct
Nov
Dec
Jan
Figure 5
Note how the final 2 cuts seem to have done the job.
Diverse Credit Markets: The following articles describe the important role played by
banks during the Russian crisis. In the second article, Alan Greenspan shares his
thoughts on the benefits of having diverse credit markets.
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September 27, 1999
Greenspan Discusses Global Crises
In Address to World Bankers
Following is the prepared text of remarks by Federal Reserve Chairman Alan Greenspan
before the World Bank Group and the International Monetary Fund, in Washington, Sept.
27, 1999.
Lessons from the Global Crises
With the benefit of hindsight, we have been endeavoring for nearly two years to distill the
critical lessons from the global crises of 1997 and 1998. From what seemed at the time to
be isolated and contained disruptions in Thailand and Indonesia, economic turmoil
deepened and spread, ultimately engulfing the emerging-market economies of East Asia
and other parts of the globe and then the financial markets of industrial countries.
The failure of normal adjustment processes to contain the financial turmoil made this
crisis longer and deeper than any of us had expected in its early days. One possible clue
to this breach may reside not in the events leading up to the East Asian crisis in the spring
of 1997, but rather in the extraordinary episode of financial market seizure that afflicted
some emerging-market and industrial-country markets, particularly in the United States, a
year ago.
Following the Russian default of August 1998, public capital markets in the United States
virtually seized up. For a time not even investment-grade bond issuers could find
reasonable takers. While Federal Reserve easing shortly thereafter doubtless was a factor,
it is not credible that this move was the whole explanation of the dramatic restoration of
most, though not all, markets in a matter of weeks. The seizure appeared too deep seated
to be readily unwound solely by a cumulative 75 basis point ease in overnight rates.
Arguably, at least as relevant was the existence of backup financial institutions,
especially commercial banks, that replaced the intermediation function of the public
capital markets.
As public debt issuance fell, commercial bank lending accelerated, effectively filling in
some of the funding gap. Even though bankers also moved significantly to risk aversion,
previously committed lines of credit, in junction with Federal Reserve ease, were an
adequate backstop to business financing.
With the process of credit creation able to continue, the impact on the real economy of
the capital market turmoil was blunted. Firms were able to sustain production, business
and consumer confidence were not threatened, and a vicious circle—an initial disruption
in financial markets leading to losses and bankruptcies among their borrowers and thus
further erosion in the financial sector—never got established.
What we perceived in the United States in 1998 may be an important general principle:
Multiple alternatives to transform an economy’s savings into capital investment offer a
set of backup facilities should the primary form of intermediation fail. In 1998 in the
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United States, banking replaced the capital markets. Far more often it has been the other
way around, as it was most recently in the United States a decade ago.
Highly leveraged institutions, such as banks, are, by their nature, periodically subject to
seizing up as difficulties in funding leverage inevitably arise. The classic problem of bank
risk management is to achieve an always elusive degree of leverage that creates an
adequate return on equity without threatening default.
The success rate has never approached 100 percent, except where banks are credibly
guaranteed, usually by their governments, in the currency of their liabilities. But even that
exception is by no means ironclad, especially when that currency is foreign.
When American banks seized up in 1990, as a consequence of a collapse in the value of
real estate collateral, the capital markets, largely unaffected by the decline in values, were
able to substitute for the loss of bank financial intermediation. Interestingly, the then
recently developed mortgage-backed securities market kept residential mortgage credit
flowing, which in prior years would have contracted sharply. Arguably, without the
capital market backing, the mild recession of 1991 could have been far more severe.
Similarly Sweden, like the United States, has a corporate sector with a variety of nonbanking funding sources. Bank loans in Sweden in the early 1990s were concentrated in
the real estate sector, and when real estate prices also collapsed there, a massive
government bailout of the banking sector was initiated. The Swedish corporate sector,
however, rebounded relatively quickly. Its diversity in funding sources may have played
an important role in this speedy recovery, although the rapidity and vigor with which
Swedish authorities addressed the banking sector’s problems undoubtedly was a
contributing factor.
The speed with which the Swedish financial system overcame the crisis offers a stark
contrast with the long-lasting problems of Japan, whose financial system is the archetype
of virtually bank-only financial intermediation. The keiretsu conglomerate system, as you
know, centers on a “main bank,” leaving corporations especially dependent on banks for
credit. Thus, one consequence of Japan’s banking crisis has been a protracted credit
crunch. Some Japanese corporations did go to the markets to pick up the slack. Domestic
corporate bonds outstanding have more than doubled over the decade while total bank
loans have been almost flat. Nonetheless, banks are such a dominant source of funding in
Japan that this nonbank lending increase has not been sufficient to avert a credit crunch.
The Japanese government has intervened in the economy and is injecting funds in order
to recapitalize the banking system. While it has made some important efforts, it has yet to
make significant progress in diversifying the financial system—which arguably could be
a key element, although not the only one, in promoting long-term recovery. Japan’s
banking crisis is also ultimately likely to be much more expensive to resolve than the
American and Swedish crises, again providing prima facie evidence that financial
diversity helps limit the effect of economic shocks.
This leads one to wonder how severe East Asia’s problems would have been during the
past eighteen months had those economies not relied so heavily on banks as their means
of financial intermediation. One can readily understand that the purchase of unhedged
short-term dollar liabilities to be invested in Thai baht domestic loans (counting on the
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dollar exchange rate to hold) would at some point trigger a halt in lending by Thailand’s
banks. But why did the economy need to collapse with it? Had a functioning capital
market existed, the outcome might well have been far more benign.
Before the crisis broke, there was little reason to question the three decades of
phenomenally solid East Asian economic growth, largely financed through the banking
system, so long as the rapidly expanding economies and bank credit kept the ratio of
nonperforming loans to total bank assets low. The failure to have backup forms of
intermediation was of little consequence. The lack of a spare tire is of no concern if you
do not get a flat.
East Asia had no spare tires. The United States did in 1990 and again in 1998. Banks,
being highly leveraged institutions, have, throughout their history, periodically fallen into
crisis. Where there was no backup, they pulled their economies down with them. One can
wonder whether in nineteenth century United States, when banks were also virtually the
sole intermediary, the numerous banking crises would have periodically disabled our
economy as they did, had alternate means of intermediation been available.
In dire circumstances, modern central banks have provided liquidity, but fear is not
always assuaged by cash. Even with increased liquidity, banks do not lend in unstable
periods. The Japanese banking system today is an example: The Bank of Japan has
created massive liquidity, yet bank lending has responded little.
With very large nonperforming loans of indeterminate value, the size of capital in
Japanese banks is difficult to judge. The periodic eruption of the so-called Japanese
funding premium in recent years attests to the broad degree of uncertainty of the viability
of individual banks. This understandably creates considerable caution on the part of
Japanese bank loan officers in committing scarce bank capital. But unlike the United
States and Sweden a decade ago, alternate sources of finance are not yet readily available.
The Swedish case, in contrast to America’s savings and loan crisis of the 1980s and
Japan’s current banking crisis, also illustrates another factor that often comes into play
with banking sector problems: Speedy resolution is good, whereas delay can significantly
increase the fiscal and economic costs of a crisis. Resolving a banking-sector crisis often
involves government outlays because of implicit or explicit government safety net
guarantees for banks. Accordingly, the political difficulty in raising taxpayer funds has
often encouraged governments to procrastinate and delay resolution, as we saw during
our savings and loan crisis. Delay, of course, can add to the fiscal costs and prolong a
credit crunch.
The annals of the United States and others over the past several decades tell us that
alternatives within an economy for the process of financial intermediation can protect that
economy when one of those financial sectors experiences a shock. But the mere existence
of a diversified financial system may well insulate all aspects of a financial system from
breakdown. Australia serves as an interesting test case in the most recent Asian financial
turmoil. Despite its close trade and financial ties to Asia, the Australian economy
exhibited few signs of contagion from contiguous economies, arguably because Australia
already had well-developed capital markets as well as a sturdy banking system. But going
further, it is plausible that the dividends of financial diversity extend to more normal
times as well.
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It is not surprising that banking systems emerge as the first financial intermediary in
market economies as economic integration intensifies. Banks can marshal scarce
information about the creditworthiness of the borrower to guide decisions about the
allocation of capital. The addition of distinct capital markets outside of banking systems
is possible only if scarce real resources are devoted to building a financial infrastructure.
It is a laborious process whose payoff is often experienced only decades later. It is thus
difficult to initiate, especially in emerging economies that are struggling to edge above
the poverty level. They perceive the need to concentrate on high short-term rates of return
to capital rather than accept more moderate returns stretched over a longer horizon. We
must continuously remind ourselves that financial infrastructure comprises a broad set of
institutions whose functioning, like all else in a society, must be consistent with the
underlying value system and hence its time preference.
On the surface, financial infrastructure appears to be a strictly technical concern. It
includes accounting standards that accurately portray the condition of the firm, legal
systems that reliably provide for the protection of property and the enforcement of
contracts, and bankruptcy provisions that lend assurance in advance as to how claims will
be resolved in the inevitable result that some business decisions prove to be mistakes.
Such an infrastructure in turn promotes transparency within enterprises and corporate
governance procedures that will facilitate the trading of claims on businesses in open
markets using standardized instruments rather than idiosyncratic bank loans. But the
development of such institutions is almost invariably molded by the culture of a society.
The antipathy to the “loss of face” in Asia makes it difficult to institute, for example, the
bankruptcy procedures of western nations. And even the latter differ from one another
owing to deep-seated differences in views of creditor-debtor relationships. Arguably the
notion of property rights in today’s Russia is subliminally biased by a Soviet education
that inculcated a highly negative view of individual property ownership. Corporate
governance that defines the distribution of power, of course, invariably reflects the most
profoundly held societal views of the appropriate interaction of parties in business
transactions.
It is thus not a simple matter to append financial infrastructure to an economy developed
without it. Accordingly, full convergence across countries of domestic financial
infrastructure or even of the international components of financial infrastructure is a very
difficult task.
Nonetheless, the competitive pressures toward convergence will be a formidable force in
the future if, as I suspect, additional forms of financial intermediation will be increasingly
seen as benefiting an economy that develops capital markets. Moreover, a broader
financial infrastructure will also likely be seen as strengthening the environment for the
banking system and enhancing its performance. The result almost surely will be a more
robust and more efficient process of capital allocation, as a recent study by Ross Levine
and Sara Zervos suggests._1
Its analysis reinforces the conclusion that financial market development improves
economic performance, over and above the benefits offered by banking sector
development alone. The results are consistent with the idea that financial markets and
banks provide useful, but different, bundles of financial services.
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It is no coincidence that the lack of adequate accounting practices, bankruptcy provisions,
and corporate governance have been mentioned as elements in several of the recent crises
that so disrupted some emerging-market countries. Had these elements been present,
along with the capital markets they would have supported, the consequences of the initial
shocks of early 1997 may well have been quite different.
It is noteworthy that the financial systems of most continental European countries
escaped much of the turmoil of the past two years. And looking back over recent decades,
we find fewer examples in continental Europe of banking crises sparked by real estate
booms and busts or episodes of credit crunch of the sort I have mentioned in the United
States and Japan.
Until recently, the financial sectors of continental Europe were dominated by universal
banks, and capital markets are still less well developed there than in the United States or
the United Kingdom. The experiences of these universal banking systems may suggest
that it is possible for some bank-based systems, when adequately supervised and
grounded in a strong legal and regulatory framework, to function robustly.
But these banking systems have also had substantial participation of publicly owned
banks. These institutions rarely exhibit the dynamism and innovation that many private
banks have employed for their, and their economies’, prosperity. Government
participation often distorts the allocation of capital to its most productive uses and
undermines the reliability of price signals. But at times when market adjustment
processes might have proved inadequate to prevent a banking crisis, such a government
presence in the banking system can provide implicit guarantees of resources to keep
credit flowing, even if its direction is suboptimal.
In Germany, for example, publicly controlled banking groups account for nearly 40% of
the assets of all banks taken together. Elsewhere in Europe, the numbers are less but still
sizable. In short, there is some evidence to suggest that insurance against destabilizing
credit crises has been purchased with a less efficient utilization of capital. It is perhaps
noteworthy that this realization has helped engender a downsizing of public ownership of
commercial banks in Europe, coupled with rapid development of heretofore modest
capital markets, changes which appear to be moving continental Europe’s financial
system closer to the structure evident in Britain and the United States.
Diverse capital markets, aside from acting as backup to the credit process in times of
stress, compete with a banking system to lower financing costs for all borrowers in more
normal circumstances. Over the decades, capital markets and banking systems have
interacted to create, develop, and promote new instruments that improved the efficiency
of capital creation and risk bearing in our economies. Products for the most part have
arisen within the banking system, where they evolved from being specialized instruments
for one borrower to having more standardized characteristics.
At the point that standardization became sufficient, the product migrated to open capital
markets, where trading expanded to a wider class of borrowers, tapping the savings of
larger groups. Money market mutual funds, futures contracts, junk bonds, and assetbacked securities are all examples of this process at work.
144
Once capital markets and traded instruments came into existence, they offered banks new
options for hedging their idiosyncratic risks and shifted their business from holding to
originating loans. Bank trading, in turn, helped these markets to grow. The technologydriven innovations of recent years have facilitated the expansion of this process to a
global scale. Positions taken by international investors within one country are now being
hedged in the capital markets of another: so-called proxy hedging.
But developments of the past two years have provided abundant evidence that where a
domestic financial system is not sufficiently robust, the consequences for a real economy
of participating in this new, complex global system can be most unwelcome.
Improving deficiencies in domestic banking systems in emerging markets will help to
limit the toll of the next financial disturbance on their real economies. But if, as I
presume, diversity within the financial sector provides insurance against a financial
problem turning into economy-wide distress, then steps to foster the development of
capital markets in those economies should also have an especial urgency. And the
difficult ground work for building the necessary financial infrastructure—improved
accounting standards, bankruptcy procedures, legal frameworks and disclosure—will pay
dividends of their own.
The rapidly developing international financial system has clearly intensified competitive
forces that have enhanced standards of living throughout most of the world. It is
important that we develop domestic financial structures that facilitate and protect our
international financial and trading systems that, aside from their periodic setbacks, have
brought so much good.
Footnotes
1 Ross Levine and Sara Zervos, “Stock Markets, Banks, and Economic Growth,”
American Economic Review, vol. 88 (June 1998), pp. 537-558. (Return to text.)
Russian Crisis Terms to be familiar with:
1. Margin calls
2. Public capital markets
3. Lack of liquidity
4. Diverse credit markets
5. Commercial paper
6. The paper-bill spread
7. The corporate bond market
8. Collateral
9. Risk aversion
10. Emerging market bonds
11. Risk premium
12. Psychology of going from one side of the boat to the other
13. The amount was irrelevant
14. Spooking the markets
15. Credit rating
16. Back-up line of credit
145
17. Bond market rally
18. Safe haven of US securities
19. Hedge funds
20. Credit markets locking up
Practice Essay Questions
1. Explain the similarities and differences between the Russian crisis and the East Asian
Crisis. Be specific and take a broad approach discussing the influences on economies
around the world as well as the US economy.
2. What exactly is a spare tire as it applies to the Russian crisis? Explain and then give
examples of countries that have a spare tire and countries that don’t. Explain why having
a spare tire is so awesome, both in good times and bad, and comment on the difficulty of
obtaining a spare tire. Finish your essay commenting on the potential for Europe and
Japan acquiring a spare tire.
3. Explain the issues surrounding the Fed’s first cut in the fall of 1998. Provide
arguments why it was considered a fumble as well as providing counter arguments why it
was not a fumble at all. In your answer be sure to define and use the efficient market
theory.
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