Sunday, 21 September 2014

Two-Handed Economists


"A sign of a good economist is he or she always has two hands" says John Cochrane. Truth is, there is more to that statements than commonly thought and it is one of the things most forgotten in the economics profession. More often than not, when an economist is asked to provide an opinion on a subject, the assurance of absolute knowledge in his or her words is staggering. It is as if God Himself has come down to earth and bestowed that person with the impeccable ability of perfect foresight. In addition, the economist was also granted with the ability of saying that everybody who disagrees with him is just plain ignorant.

The problem most economists commonly ignore (maybe due to biases than other things) is that there are actually two sides in everything, from the plainest decision to the most intrigue problem the economy faces. The smart thing would be to recognise both but choose the one with less downside. For example, when the Federal Reserve chose to boost the economy by promoting programmes such as the TARP and large-scale QE they were faced with two options: do nothing and watch the whole economy collapse or do something and risk being told off for inducing moral hazard. Obviously the latter was the worse of two evils. (In case you were wondering, even with the total collapse of the economy the top 1% would still be the top 1%; the inequality would have just been greater- see the certainty I was talking about before?).

Take another example: what do you think about the government spending more than now? Most who say that this is a good idea are in danger of being labelled as communists while those who say that it is bad are about to be called Austrians. The problem here is that the question is very vague: when, for example would be a good clarification. In times of crises those labelled Keynesians would respond. But again, it depends on where you spend it and how constrained you are. Greece, Italy, Cyprus and Portugal cannot increase government spending as they are too indebted for that. In addition, moral hazard comes in again. If I am due to spend every time things go bad, why shouldn't everyone just be risky? Again, the lesser of two evils is the wisest choice here.

Probably all issues could be benefited from a two-handedness approach. Even extreme ones such as cartel formation. We all know that cartels are bad, simple because they tend to charge higher prices. Suppose now that we have a situation where a cartel is formed in an industry. In the case where no cartel exists, every firm competes by price and the lowest bidder wins. But in the case where the cartel exists, the firms agree that one of them would win each time and place higher prices. Is this bad for the state? Obviously. Is this bad for the economy? Well, it depends. If, as usual we have returns to scale, it would mean that less people are employed in a single firm than in two similar firms. In this case, the lowest bidder would get all the auctions and everyone else would be left off the market. But, at the same time more unemployment would occur than if all firms were operating as one firm needs less than all the workers! 

As the reader may observe, there is no clear-cut answer to a question. Even in this most extreme of cases such as the one where cartels are involved, what would you prefer if you were a policymaker during a crisis and unemployment was already sky high? High morals and high unemployment with less spending or lower morals and lower unemployment with more spending? My answer is simple: it depends.

Saturday, 2 August 2014

Comments on the PIMCO report for Cyprus

Since the PIMCO report on the Banking System of Cyprus became public information, I've actually noticed much less comments regarding it than when it was still considered confidential. The reason might simply be that it is always much more difficult to speculate on something which is available to everyone than something which is supposed to be a secret. Thus, given the lack of comments on the subject, what follows is my take on the report.

The first thing you notice in the report is that PIMCO did an excellent job in identifying the major features of the Cyprus banking system. The most important of these features are:

1. The prevalence of asset-based lending practices
In essence, Cypriot banks lent out money only if you had some strong collateral to back your loan (in most cases real estate), with less attention given to whether the client had the ability to actually meet payments. If the borrowers got into trouble, they could always sell their property to repay their loans; as real estate prices increased for a very long time, this practice rarely yielded losses for the banks. Most importantly, borrowers who were not able to repay could always pledge more collateral and actually increase the amount of they borrowed.

2. Extended foreclosure and legal resolution timeline
Simply put, if a borrower could not repay his loan, then the whole procedure of obtaining the collateral and making a forced sale of the property ranged between 10 to 12 years. Add this to the previous feature and the reader may easily see that a borrower had no difficulty in pledging more collateral and obtaining more credit as there is almost zero downside on his part. This in its turn artificially increases loans and leads to the concentration of bad loans to few people (see land developers, hoteliers, etc).

3. Different provisioning methodology, impairment recognition and interest income practices
Notably, a fully-secured loan was not considered a non-performing one which makes the value of NPLs depend on the (subjective) valuation of the collateral. In addition, unpaid interest income was also considered to be income as a result of the historically appreciating property prices which made the probability of future losses very few (as also discussed in feature 1).

In addition to these, a high reliance on the the international banking operations for income and non-residents for funding was also reported. These features resulted in high cure rates for NPLs as well as high re-default rates (since extra collateral means a "cured" NPL but does not mean that the borrower's ability to repay has increased) and subsequently in high probabilities of borrower default but low loss-given-default rates due to over-collateralization.

The methodology of the exercise, will not be the subject of this article, yet, just simply comment that even though there has been much speculation, PIMCO does not appear to do anything different than standard procedure. The same holds for the base scenario which does not appear unrealistic given the European Commission (EC) forecast in Autumn 2012. Actually, compared to the -2.3%, -1.7% and -0.7% EC forecast for 2013, 2014 and 2015 respectively, the -3%, -0.6% and 0.8% is cumulatively much rosier. The same holds for the unemployment rate forecast.

The finding which most strikes out in the report is that Cyprus banks were unable to meet their capital needs even in the base scenario. In fact, not only would they need additional capital to meet regulatory needs but they would also end up with negative capital in 2015, making an additional case against the validity of the EBA stress test exercises in 2011. Again, I note that this is simply the base scenario. In the adverse scenario, the capital needs increase by more than 3 billion euros for the whole system.

The PIMCO numbers are supposedly the ones on which the decision on the percentage of the deposits haircut of the Bank of Cyprus  relied on. The 3.9 billion shortfall for the bank was very close to the 3.8bn obtained from the haircut. The problem, however, lies somewhere else: as stated in page 8 of the report "Greek loans represented approximately 40% of the defaulted balances. Moreover, in the adverse scenario [..] Greek loans represent 43% of total expected losses on Cyprus and Greek loans". In numbers, out of the total of 6.6 billion expected losses on loans and advances, around 2.8bn were from Greece. For those who have forgotten, MoU in March 2013 also included the forced sale of the banks' subsidiaries in Greece. This means that the banks were cut off from any potential losses in Greece thus lowering their capital needs. Even if we round the number of the PIMCO report to 2bn euros, the capital needs in the adverse scenario reduce to about 1.9 bn, without even taking into account the reduction in risk-weighted-assets which would further decrease needs.

Hence, the question which arises from the PIMCO report is: since the forecasts were made using the Greek branches as well, why was the amount employed in the haircut the same? In fact, since the Bank of Cyprus actually required a further re-capitalisation of close to 1 bn a few days ago, how low have the PIMCO estimates been? The only major difference which could make the actual outcome worse than the predicted is the fact that unemployment was 16% in 2013 rather than 13.8% in the forecast, while the house price forecast was much more pessimistic than the actual result. The change in the NPL definition does not matter at all, as PIMCO, in page 15, defines a non-performing loan as one which is 90 days past due, regardless of its collateral amount. The good Laiki couldn't have impaired the balance sheet by that much either since most of the losses were absorbed by the bad bank. Even in the worst case scenario of BoC obtaining all loans from Laiki, the exclusion of the Greek branches leaves capital needs for the domestic Laiki at less than 1bn. Strangely, the liquidation of Laiki was said to decrease Cyprus's needs by 4.2 billion which is in contrast to the PIMCO report in which the bank required 3.9 billion in total (including the Greek branches).

Concluding, the big question mark here is not if PIMCO over-estimated the capital needs of the banks, but why its numbers when it came to the Cyprus evolution of loans were so far off. If the BoC actually needed 4.8 bn (3.8bn of the haircut plus 1bn from the re-capitalisation) to pass the October stress tests why was the number less than 2 billion (excluding the Greek branches) in the PIMCO report? 

The PIMCO report, even though it did a great job in identifying and analysing the state of the Cyprus banking system did a very peculiar job in forecasting its capital needs. Truth be told, numbers and reports don't really add up.

Saturday, 12 July 2014

A Marriage Made in Hell: Housing and Foreign Demand

In the past couple of years we have seen a surge in the effort to obtain demand from abroad. Current Account negative balances, have provoked many discussions, since in a currency union, in order not to have a Balance of Payments crisis, there is a need for having a stable quantity of money in the economy. The apparent solution of boosting the export sector, as Germany has been doing during the Eurozone crisis, is no solution for the long-run as without strong domestic consumption the country is prone to shifts in foreign demand. Yet, in the short run, this dependence on foreign demand appears to be great if demand keeps going up. 

The problem is that the same principle does not hold for housing. Picture the following scenario: a person from country Y buys a very affordable home in country X. It goes without saying that most probably country Y is richer than country X, or at least house prices in the latter are lower than the former. (The rationale behind this is that it wouldn't be easy for someone to purchase a home in a country where prices are much higher than in his own country - unless he or she is very wealthy which is what has been happening in London nowadays). Now, if the house is really affordable, others will also want a piece of the housing, and from the supply and demand law we know, prices will rise in the country.

Is that necessarily bad? The answer is unfortunately yes, most of the times. If the rise in foreign demand occurs during a relatively short period of time (as it usually manifests), then house prices will rise by much more than national inflation rates. The case of Spain is very enlightening:

Yellow line is the price of housing per square meter while the green one is the inflation rate
The first question which arises is why doesn't the inflation rate rise by as much as foreign demand if that is the main driving force behind the increase. The answer to this is inequality, but not in the Piketty sense: it is not that everyone in Spain benefits from the rise in prices. The "representative" Spanish household has no intention of selling its house and living somewhere else just because prices have gone up (I know that many economists believe that this is what "rational" agents would do, but that is not very realistic). It's the land developers who benefit the most from this expansion of prices, which is followed by an expansion in credit as banks see its profitable to lend to them. Money is still distributed along the economy in the form of credit or increased consumption (the rising trend of inflation in the above graph is indicative of this) but not by as much as the rise in property prices.

The second question is why does it matter that much. What most fail to see at the time is that this expansion in foreign demand hurts the nationals by much more than we believe. If the average price in Spain was around 1000 euros in 1997, and a part of the population could not afford to purchase a house, then who would argue that in 2008, when it nearly tripled many less would really afford it. If someone doubts this then the following graph should remove all doubt:
The increase in wages was less than 70%, when house prices rose by almost 180%. House price in 1997 was approximately 14 times the wage index, while in 2008 it was more than 28 times. Foreign demand for housing has an even nastier side: it assists in the creation of a credit bubble as locals have to borrow more money for property purchasing and land developers borrow more as profit opportunities rise. Spain is again indicative of this behaviour as credit rose by more than 400% since 1998, mostly driven by these developments.

So what makes housing so different?

The simple answer is that housing is immovable. You cannot really take a house or an apartment and leave the country as you can do with other types of goods.That makes all the difference since it means that locals and foreigners compete for the same goods. If a producer can sell a banana at home and the same one abroad, then prices are charged accordingly and, if possible, charges foreigners more, given the extra trouble that is required. In the meantime, the producer cannot really charge the foreign price to the local market because there are many other substitutes: buy from another producer, buy an imported banana or buy some other fruit. In contrast, the house is stuck where it is built and there is no local nor foreign substitute for it. In addition, the developer has a very good alternative for local demand: sell it to a foreigner at an inflated price. Which is more profitable? Obviously the latter, and the locals will just have to meet the price if they want to purchase the property.

Thus, simply put, increased foreign demand for real estate is almost always bad news for the locals. The phenomenon has not just taken place in Spain, housing bubbles have appeared in the Netherlands, Greece, Cyprus and even London as it appears nowadays. So next time you hear about rising foreign demand for real estate in your country be wary, very wary.

Wednesday, 4 June 2014

Does Supply Create Its Own Demand?


Many a policy during recent years have been aimed at making things easier for producers. The rationale has been that if producers can create more goods (or make the same goods with less money) then they will have to hire more people, thus boosting employment, consumption and growth. This understanding is based on what has been commonly known as Say's law, which states that "the mere circumstance of creation of one product immediately opens a vent for other products".

Unfortunately, this "law" does not always hold. In fact, at times it appears to be nothing more than a misunderstanding of how the world works and how businessmen think and operate. Let us consider the following example: Company X creates 100 units of good Y which it sells to the public. Demand is good so that there are no excess goods at the end of the day. However, Company X is not the only company in town; there are dozens of others which produce all kinds of goods, some substitutes of good Y, some complementary and some which are completely irrelevant.

One terrible day, some shock (say a financial breakdown) causes demand for all goods to drop by 20%. Given that firms employed as much workers as it was enough to meet demand and earn them a profit, they now begin to lay off people, until they once again meet demand, with a lower cost. For simplicity, let us suppose that there are no frictions in the economy and this correction happens very fast. Obviously, letting workers go will mean a further deterioration of demand, but we will ignore this for now and just assume that there has been a drop of just 20%. 

An additional option would be to cut workers' salaries by 20%. Yet, this is unlikely to happen because some workers would remain idle and not be fully used during their employment hours. Having them all work less is a bit unrealistic, thus a combination of wage reductions and less employment appears to be more likely. Now let's say that the government, instead of doing anything else, subsidizes part of the firm's expenses, making the good less expensive. What does this mean: basically instead of earning €1 euro per item, it now earns €2. Surely, the company's profits rise spectacularly. But does it mean that it helps the economy? Not really.

The issue here is that firms, unlike what many people people believe, hire only when they are trying to meet demand and not when profits are rising. Unless dropping the price by €1 means that there is a surge in demand for their goods enough to hire extra workers, then nothing will occur in the economy. As some goods are price inelastic then we know that reducing prices will not change their demand by much. In addition, the economy's reduced income means that people are more likely to hold off purchases, even if they can afford it, a form of buffer against worst days in the future.

What is more, even if a lower price increases demand, there appears to be a problem similar to what we know as the paradox of thrift or the prisoner's dilemma: what is good for the individual (here the firm) is not necessarily good for the economy as a whole. For instance, the first firm which will hire new workers must be certain that the demand for its goods will be sufficient to cover wages. Yet, only a very small part of those wages will be allocated to the good the worker is producing (think of it this way: an ice cream maker will not just consume ice cream). This, in its turn, benefits the other firms in the economy by much more: by incurring no expenses, they see demand for their products marginally increased. 

It is more than obvious that if a firm starts hiring then others will most likely follow, even though there is a "first mover disadvantage". The disadvantage is mitigated only if demand is persistent and large enough to cover the wages and leave room for profit. This means that Say's law most likely holds if there increased demand for goods. The magic word here is demand: even in Say's world, it takes demand to create supply not vice versa. To what avail are we to fill the market with trillions of goods if nobody wants to purchase them? Nevertheless, this is very hard to know in advance (given the lower income and reduced trust in the economy) and in addition, the cost is high: unless direct subsidies are employed then the effect of other measures such as reduced red tape or other bureaucratic hurdles is infinitesimal.

Then the big question arises: why should we subsidize firms to create cheaper goods, when we know that the outcome is uncertain, or even if the outcome is favourable, the shift will probably take very long? More so, why shouldn't we just target the demand side, which creates more growth faster and tackles issues such as poverty and unemployment much faster, while in addition it is cheaper? If we let ideological barriers such as thinking that assisting the demand side is "Keynesian/Minskian" and the supply side "Liberal/Free Market/Friedmanite", we just reach the conclusion that we are enforcing the same thing through different ways. The only problem lies in choosing wisely which way suits us better.

P.S. This article strictly refers to established firms.l Start-ups usually do create their own demand for their (new) goods, but they are not usually the ones to receive government aid as they are either at infancy level or non-existent during those times. In addition, their "new" demand lies heavily on whether the public has enough funds to purchase innovative goods, something which brings us back to original demand. Assisting in the creation of start-ups (when times are good but especially when times are bad) while simultaneously boosting demand could in fact work wonders for an economy.