Author Archives: agolicz

(Revised) Should We Print Money For Aid?

I recently sat down to watch an interesting TED talk by Michael Metcalfe, a senior managing director at State Street Global Markets, who brought up a few interesting ideas about the way we fund our foreign aid programs. Metcalfe begins the talk by introducing a few interesting observations about the global economy. He first addressing the contradiction in foreign aid policy in developed countries. Metcalfe points out that, although the United Nations has put forth the incredibly ambitious Millennium Development Goals, which include halving extreme poverty rates and halting the spread of HIV/AIDS by 2015, the ratio of foreign aid to national GDP of developed countries has stagnated around 0.35%, even though aid targets remain at 0.7% of GDP. He asserts that foreign aid payments have also dropped since the financial crisis, and that progress towards our ambitious development goals will remain slow if this problem is not properly addressed. His solution? Simply print money for foreign aid.

At the basis of Metcalfe’s idea is the suggestion that the money supply doesn’t affect inflation as drastically as many believe. He explains that despite the U.S. Federal Reserve’s multi-trilion dollar asset purchasing program, the inflation rate in the U.S. has remained relatively unaffected 6 years later. Indeed, if we use the Consumer Price Index as a strong proxy for annual inflation in the U.S., then it does appear that the price level, apart from a small and temporary increase during the recession, hasn’t dramatically risen since the financial crisis. Screen Shot 2014-04-05 at 9.19.05 PMBuilding the foundation of his argument upon this information, Metcalfe asserts that we should take a fraction of the money that was printed to stimulate the economy and send it to countries who rely on U.S. foreign aid. Like a firm that matches the charitable donations of its employees, the U.S. central government could encourage the Federal Reserve to match its contributions to its annual foreign aid payments. Furthermore, since these payments would be going overseas, he explains that it’s not obvious how this form of funding would directly contribute to inflation in the central bank’s home country. According to Metcalfe, this could dramatically increase the amount of foreign aid payments to developing countries with limited risk to creating inflation and smaller requirements from the central government’s coffers.

At first glance this looks like a very interesting idea, and one that seems certain to garner praise. I mean, who wouldn’t want to eliminate eliminate global poverty with a few keystrokes from the FED? On the other hand, there do appear to be a few inconsistencies with his logic and methods that could prove problematic. First, I would be careful not to make the assumption that just because inflation didn’t appear to increase much after QE, that printing money doesn’t cause high levels of inflation. While it is true that the central banks of the U.S., UK, and Japan created around $3.7 trillion to help push the global economy out of a recession, that doesn’t mean that all of this money made it out into the economy. As we’ve all learned in Econ 102, the Federal Reserve adjusts the money supply though Open Market Operations, in which it buys securities from national banks. These banks are then supposed to take this newfound money and loan it out to individuals, whereupon it the money will have a multiplicative effect after individuals deposit their loans in other banks, who lend out a share of this money to other individuals, who deposit it in other banks, so on and so forth. A problem occurs, however, when banks decide not to lend money to individuals. This was an apparent phenomenon during the financial crisis when banks decided to hold on to the Fed’s newly invented money in in fears of the risk of financial collapse. We actually see there is a steep decline in the number of loans make by commercial banks after the financial crisis, so not all the money created by the fed actually entered the U.S. economy. Therefore, it’s not fair to use the Fed’s dramatic monetary policy and subsequent small blip in price levels during the recession as evidence that we could simply print money for aid without affecting inflation. Screen Shot 2014-04-05 at 10.25.44 PM

 

It seems surprising that a senior managing director and supposed global macroeconomic expert would make such a statement based on shaky evidence, so perhaps he is more privy to the more quantitative effects of QE on inflation than he lets on in his talk (he only has 15 minutes after all). Regardless, I would also contend that his strategy may also fail on practical terms as well.

Let’s assume that hypothetically the Fed liked this idea and wanted to enact this as part of its monetary policy. In order to legally make the donation, the Fed would likely have to enact open market operations in foreign countries by buying up bonds from central banks (or, if absent, the central government) in developing countries. While the Fed might expect that the banks would lend this money out to the citizens, thus stimulating the local economy, this may backfire given higher levels of corruption in these developing countries (corrupt and ineffective governments are often important reasons why many countries remain in the “third world”). Many of the most impoverished countries do in fact score highest on indices of political corruption, such as Sudan and Haiti. These banks and governments may decide to shower the money upon themselves, leaving the citizens still impoverished. Furthermore, government debt in third world countries is likely to be far riskier than in developed countries, and the bonds are more likely to loves their value and perhaps even become worthless. In these cases the Fed might be accused of the wasteful funneling of money to corrupt dictators and enterprises. Therefore, it would be unlikely that the Fed could effectively channel foreign aid to developing countries and ensure that the funds would reach the citizens and companies that need them most.

Overall, these are only a few of the many problems the Fed would face if it actually decided to consider this type of policy. It appears that there may be some large problems in Mr. Metcalfe’s solution to the foreign aid gap that would have to addressed before this could become feasible government policy.

 

Earth-Like Planet Discovered, Krugman Already Exploring Space Economics

This week, NASA astronomers at the SETI institute discovered a planet nearly the size of earth that may be the right temperature for liquid water. According to the Wall Street Journal’s report of the announcement, the planet Kepler-186f is located in the habitable zone of a star located around 459 light years away from earth in the constellation Cygnus. A habitable zone is the region around a star in which a planet receives just enough solar radiation such that it maintains a temperature where liquid water could exist without freezing or boiling, and thus may make this planet more likely to have life-sustaining conditions. While many scientists still contend that this planet may still be too cold to sustain liquid water without a greenhouse-like atmosphere, many astronomers are excited to add Kepler-186f to the list of 9 potentially habitable alien worlds that could potentially be studied in the far away future.

While its safe to say that we won’t be colonizing any of these planets for at least a millennium (a round trip to Kepler-186f would take over 900 years even if you travel at the speed of light), that hasn’t stopped Paul Krugman from using his clout at the New York Times to publicize his theories on interstellar finance that he published in 1978. In the realm of untestable economics theories (which is a pretty large area), this has to be the most ridiculous. On the other hand, it does appear to contain relatively logical rhetoric and a few equations borrowed from physics, so therefore it must be worthy of the grant funding Krugman obtained to write it, right? (He actually did get a grant to write this paper, albeit from the committee to re-elect William Proxmire, a Wisconsin Senator)

Despite eventually being published in an economic journal (which makes me wonder what won’t get published in economics), Krugman intends this article to be a well-crafted comedic article. In his quest to address the problem of computing interest charges on goods in transit while at the speed of light, Krugman writes:

“A solution is derived from economic theory, and two useless but true theorems are proved.”

In case the readers didn’t yet know that this work was meant as a farce, Krugman also adds:

“Is it too much to suggest that current work might prove as influential in this development as the work of Adam Smith was in the initial settlement of Massachusetts and Virginia?” (Hint: Adam Smith was born in 1723, while the Massachusetts Bay Colony was settled in the 1620’s)

Despite the humorous undertones, Krugman’s theory appears to be grounded in Einsteinian physics theory. The main problem in accounting for interest in interstellar trade addressed by Krugman is that time is relative to the observer. The theory of relativity explains that the time experienced by one observer, here described as (delta t’) depends on the velocity of the other observer.

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As the speed of observer A approaches the speed of light, the change in time experienced by observer B from the perspective of observer A will approach infinity. For a real life example, this means that a clocks on a satellite traveling around the earth in orbit at 7.7km/sec will be approximately 0.007 second slower than a clock on earth (GPS satellites have to correct for this effect in order to accurately track its position in orbit). So getting back to Krugman’s example, if a light-speed-traveling starship left earth to a far away planet to deliver a payload of goods to the planet “Tantor,” by the theory of general relativity the time experienced by those on the starship would be much shorter than that experienced by those on either Earth or Tantor. Therefore, assuming that the starship was only a transport vessel (rather than a traveling city), one should calculate interest based on the clocks in the “common frame,” or the clocks on the respective planets, rather than on the clock onboard the transport vessel. Furthermore, By Krugman’s second theorem, competition will equalize the interest rates on the two planets.

This analysis of course makes a few oversimplifications. First, although the interest rates may equalize between the two planets in theory, in reality it would take almost 500 years to even find out what the current interest rate is on the other planet. Therefore, it would be necessary for the interest rates to remain very static on each planet while the other planet waits to obtain the knowledge of the interest rate on the other planet, which would certainly be highly unrealistic given typical human political conditions (we might not even use the same currency, nor have the same governmental systems on earth by the time we found out the interest rate on Tantor. Second, it assumes that at some point we would be able to travel at near light speeds (no explanation needed).

Overall, the article makes for a fun and interesting read. It’s unlikely that these theorems would be used in the next millennium (who knows, maybe Krugman will become the future Socrates for his far-reaching philosophical theories). In the end, I’m still confused about how such a busy intellectual academic like Paul Krugman found the time to write this.

Sliding Stocks Carry Hedge Funds Downwards, Few Worry of Bubble

2014 has been a rough year for internet tech and biotech stocks. Despite their 2013 gains, recently Google has fallen around 10% since last month, and Valeant Pharmaceuticals Intl Inc. has fallen over 17% since February. While the recent dip in the stock market has impacted many investors over the past few months, according to the Wall Street Journal, many top hedge funds have been hit especially hard.

It sounds like many hedge funds, not wanting to be left behind, jumped into stocks in the beginning of the year after watching last year’s bull-market rally. However, those that increased their exposure to last year’s darling companies have often seen their lackluster returns drastically missing the S&P 500 average. For instance, while the S&P 500 has been down around 1.2% since the beginning of this year, the $28 billion large hedge fund Viking Global Investors LP has fallen more than 4% in both march and april. John Thaler, a former analyst at the tiger cub hedge fund Shumway Capital, saw his $2.2 billion JAT Capital Management fund take a 10% loss for the year (on a side note, the tiger cubs are hedge funds that spun off of Julian Robertson’s famed Tiger Management Corp hedge fund that, although incredibly successful in the later 1990s, eventually went bust when its largest holding in U.S. airways crashed in 2000).

The culprit behind the lackluster returns of these hedge funds, according to Brian Shapiro, founder of the hedge-fund analytics company Simplify LLC, is that duplication has become common among hedge fund managers. Many firms end up placing the same bets, either by independently coming to the same conclusions about stocks or, more likely, because they hope to ride a momentum wave by copying the strategies of other hedge fund managers. This inevitably pushes up the price of the asset that everyone is buying, and creates “wealth” on paper, but if a few of these managers get smart and decide to sell to lock in their winnings, the stock begins to sink all of their boats will capsize together.

To me, this kind of speculative behavior seems to be the kind that could form a bubble, since people are attempting to make a profit on the rising price of an asset by investing in places where others have already made money. However, according to Vikram Mansharamani, a lecturer at Yale University who has written extensively about how to detect a bubble, this may not be the case.

In an interview with the Wall Street Journal, Dr. Mansharamani outlines 3 red flags that may signal a potential bubble.

  1. Rapid Rise in Prices: In the beginning of a bubble, investors push up the price of an asset quickly. For instance, in the year before the dot-com bubble the Nasdaq rose 110%. Also, the price spike might also be interspersed with panicked selling, says Professor Didier Sornette, who holds the Chair of Entrepreneurial Risks at the Swiss Federal Institute of Technology Zurich (ETH Zurich).
  2. Prices Breaking from Asset’s Underlying Value: Using the Shiller P/E, which is the market price for an asset divided by the 10-year inflation adjusted average earnings, a high ratio may indicate a bubble. For instance, while the median P/E ratio of large U.S. stocks has been around 16 since the late 1800s, but during the dot-com bubble the Shiller P/E surpassed 44.
  3. “Exciting”  innovation as justification for the price increase: If, in an effort to justify their irrational exuberance, investors point to new technological innovations as a rational cause for the price increase, there’s reason to be skeptical. This can be seen in both the dot-com boom and in the housing crisis (with the popularity of innovations in mortgage-backed derivatives). Overall, it’s important to remember that irrational people will find a way to rationalize anything.

By these criteria, the overall S&P 500 may not be in a bubble. Although the S&P 500 returned 32% last year, it’s Shiller P/E is only around 25, which is somewhat worrisome but not yet alarmingly indicative of a bubble. Professor Sornette’s models did, however, identify internet retail stocks and healthcare and life-sciences stocks as bubbles before the recent sell-off. As evidence, the Nasdaq biotechnology index has fallen more than 18% since the beginning of the year after last year’s rapid ascent.

 

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On the other hand, the famous Bitcoin does meet the criteria for a bubble. The price has exploded in the past year, rising from a low of around $120 last April to a high of near $1126 last December. Investors have also justified its ascent due to its “innovation” and “potential to change the world” (just see the website bitcoinquotations.com for a list of quotes from hyped up entrepreneurs, economists, and politicians), while the fact remains that few retailers currently accept payment in Bitcoin and there are no underlying assets backing the currency. This is not to say that Bitcoin, or a similar technology, won’t be important to the future of finance, it just suggests that Bitcoins recent gains are likely the result of hype and popularity.

Overall, It’s important to remain level headed and rational when investing, as even institutional investors and hedge fund pros can and often do make poor bets.

Hedge Funds’ “Appraisal Arbitrage”: Profiting from Buyouts

Dole Food Co., the relatively unexciting agricultural corporation and famous pineapple producer, became the center of an increasingly popular trend in hedge fund investing during its recent buyout. According to the Wall Street Journal, last year Dole Food Co. sold itself to its founder, in this case by purchasing all of the public shares in order to take a public company private. While most investors would have seen this as an average buyout, a few hedge fund managers took the opportunity to use an old legal strategy called “appraisal arbitrage” to grab a slice of the profits from the deal.

According to Latham and Watkins, one of the world’s most profitable law firms, appraisal rights have “historically been a back-water of the public company M&A process and practice, largely ignored and often thought irrelevant.” Well, not anymore. In a nutshell, appraisal arbitrage is a strategy in which a minority of investors purchase a large minority share of a public company just before the shareholders vote to decide whether to accept the terms of a buyout. Appraisal rights are the statutory rights of a minority shareholder to seek a fair stock price determined by a 3rd party appraiser and for the acquiring entity to repurchase the shares for the fair price. Basically, these hedge fund managers are purchasing shares of companies which have entered into undervalued buyout deals, forcing a fair appraisal of the company’s assets through judicial order, and then profiting from the presumably more generous valuation.

This supposedly previously obscure strategy has been gaining popularity in recent years. According to the Wall Street Journal:

Appraisal claims were brought on 17% of takeovers of Delaware companies in 2013, the most since at least 2004, according to a coming study from Brooklyn Law School and Case Western Reserve University. Based on deal prices, those claims were valued at $1.5 billion, an eightfold increase from 2012.

One potential risk to this strategy is a stipulation in the rule that states that the investors who wish to request a fair appraisal must either vote no or abstain in the decision to proceed with the buyout, and they must not make up the majority. This means that if the investors own more than 50% of the shares, then this rule doesn’t hold and the buyout simply doesn’t go through and nobody profits. The hedge funds investing in the Dole Foods Inc. buyout were lucky, as the buyout passed with just 50.9% of the vote. Overall, this is one strategy where it pays to know something that no one else knows.

While it appears to be based upon fair law and is therefore a legal strategy for investors, its abuse potential, just like high-frequency trading and hostile takeovers, could be grounds for a healthy dose of skepticism about whether it’s ethical for outside investors to meddle in others’ purchases. However, in many cases, it seems that this strategy is one in which the rest of the shareholders of a company may also enjoy the benefits of a more fair valuation of the share price. At the very least, it forces a second opinion in the determination of a company’s fair value. In the end, this is a zero-sum game, and therefore is an issue in which many economists and investors will likely disagree about the ethics.

 

 

Rising Rate ETFs

In a Weekend Investor article in the Wall Street Journal, the author Joe Light describes how trends in bond ETFs are changing amid the expected rise in interest rates in the near future. ETF, which is an acronym for Exchange Traded Fund, is essentially a portfolio of assets that typically track some underlying index. For instance, if you were to purchase one of the popular SPDR S&P 500 ETF (pronounced “spider”), you’re essentially buying a small piece of every company within the S&P 500 stock index basket. There are many benefits to buying a low-cost ETFs, including the possibility of diversification and liquidity. A good primer on ETFs can be found from the youtube channel of Blackrock, which is an asset management firm and industry leader in ETF investments. 

ETFs can offer investors greater liquidity than through investing in individual securities because, while the overall size of the ETF may be large, the size of the holdings of any given asset within the ETF is much smaller. For instance, if someone purchased $1Billion worth of single company, or a small portfolio of companies, and later decided to sell all of their shares at once in what is called a “fire sale,” then the added supply of shares in the market would cause the underlying asset prices to drop. In this case, the investor might have to sell for a significant loss to get his/her money out right away. However, if one bought $1 Billion worth of  SPDR “SPY” ETFs based on the S&P 500 and decided to sell the whole ETF at once, the prices of the underlying assets might shrug off the effects. In this case, you may have only invested $2 million in each company (assuming equal weights within the portfolio), which is typically not enough to dramatically affect the supply and price of an asset.

An ETF can cover a range of assets as narrow as a single industry such as oil and gas, or as broad as an entire market, so an investor can essentially choose how diversified their portfolio is. For instance, if you were an investor that had purchased a diversified international equities index fund, but were hoping to also hedge your investments against fluctuations in stock market, one could buy a bond ETF that would be composed of assets like Government Treasury Bonds, Corporate Bonds, or asset backed securities.

While bond portfolios might in normal times make an attractive investment for those wishing to diversify their portfolios, many investors are currently hesitant to touch them due to expectations of a rise in interest rates in the near future, given the U.S. Federal Reserve’s decision to begin to wind down its quantitative easing purchases. So if the artificial demand for bonds created by the FED will soon be lifted, likely causing bond yields to increase and prices to drop, how can a bond investor sensibly make money on these trades? The answer is hedging.

Many companies including Blackrock and WisdomTree Investments have launched plans for hedged bond ETFs that will protect investors from the ever-more-likely drop in the price of bonds. One such ETF is called a zero-duration ETF, which is a portfolio that both goes “long” on bonds (meaning you purchase bonds) while going “short” on certain bonds and derivatives (such as by shorting U.S. treasuries or Treasury futures contracts). In this case, a short is when you borrow a share of an asset, immediately sell it, and then pledge to the lender to return the share at a later date by purchasing another share at (hopefully) a lower price. This “hedging” allows investors to essentially place bets on both sides of the market; if interest rates and bond yields fall, then the investors profit from the rise in the price of their bonds, but if bond yields rise then the investor can offset much of the losses in their bond portfolio by the increased return from their “short” bets.

While there are many benefits to hedging, including in using hedged bond ETFs like the zero-duration ETF, the costs are also larger. Hedges can add to the cost of a portfolio because the investor must purchase instruments such as futures contracts, or place money on margin to short an asset (margin is somewhat like a security deposit; in the case that an investor can’t afford to buy back a share that it borrowed from the broker, the broker gets to keep the margin). If investors invest in high-fee hedged ETFs without looking at the annual management fees, then they might be disappointed in the size of the returns after the wealth managers take a cut. Overall, there’s a price to safety in unstable markets, so investors would be wise to consider all of the investment choices available to them before they let a broker touch their nest eggs.

Expensive Physicians Under Pressure from Medicare over Billing Practices

A number of U.S. physicians are under public scrutiny after the recent release of 2012’s Medicare billing data. According to the Wall Street Journal, the Federal data shows that the top 1% of 825,000 individual medical providers accounted for 14% of the $77 billion medicare billing recorded in 2012. A few at the top reportedly reaped the largest benefits, as the 1000 highest-paid Medicare doctors received a total of $3.05 billion in prepayments. Physicians from specialties including oncology, opthalmology, cardiology and dermatology were among the 15 highest paid specialties on average according to the data.

A number of health-care economists and data scientists suggest that the data could help pinpoint doctors who are over treating patients and performing unnecessary surgeries and expensive procedures. Fraud investigators maintain that this data could also help identify doctors and specialties that are prone to abusing the Medicare billing system and generating economic waste. This sounds like an incredibly promising development that could help make a complicated health system more transparent and lead to more cost-efficient methods of treating patients. However, there are important limits to the usefulness of this data that makes it much less illuminating than many once hoped.

For example, the data does not show the details of patient’s diagnoses, dates of procedures, or information about whether or not the treatments were successful, presumably because of strict laws governing the release of patient data to the public. This information would be critical to understanding which treatments were the most effective and whether the more expensive treatments lead to more favorable outcomes. Without this data, any answers would be highly speculative and uninformative.

Furthermore, the Medicare data only shows how much each physician billed the Federal entity, but not the physicians costs of treatment nor their private remuneration. For example, as explained in another WSJ article: 

While radiation oncology produces among the largest per-doctor payments of any specialty, only about 18% of those payments represent physician work, a smaller share than in other specialties. The remainder was meant to cover the doctors’ overhead.

What the data essentially shows is the revenue that the individuals doctors are taking in, but not their fixed or variable costs. Just like how a business with a billion dollars in revenue might make only keep a tiny fraction in profit after expenses and interest on debt, a physician too might spend much of their billing revenue on maintaining equipment, purchasing expensive but life-saving drugs, or paying their assistants and nurses on staff. Therefore, it’s hard to know which doctors are over-billing and committing fraud and which doctors are simply trying to keep up with the expensive costs of treatment. The fact that the doctors’ names are being published alongside their Medicare billing records could be potentially dangerous and create unwarranted social pressure, as the public and media may wrongly accuse top billing doctors of waste and fraud while they may simply be running unavoidably expensive but effective practices in specialties like oncology or radiology. Overall, the billing records are likely missing too much vital information to be highly informative about waste and fraudulent practices.

In my opinion, given the current information (or lack thereof), investigators and policymakers should be cautious about the conclusions they derive. While Medicare’s public release of data is an important step forward towards transparency and analysis of efficiency in the extremely complex health care system, this issue also demonstrates the necessity to harvest and legally release more data in order to obtain better analyses. Currently, obtaining medical data is hard, especially because of the necessary and important health information privacy laws that protect patients from having their medical records exploited by insurance companies and employers. However, given the fact that advances in network technology, cloud storage, and open-source data analysis platforms have proven amazing tools to derive knowledge from previously unintelligible datasets, it might be useful in the near future for regulators to consider releasing anonymous patient data under protective licenses for analysts to dissect.

Should We Print Money For Aid?

I recently sat down to watch an interesting TED talk by Michael Metcalfe, a senior managing director at State Street Global Markets, who brought up a few interesting ideas about the way we fund our foreign aid programs. Metcalfe begins the talk by introducing a few interesting observations about the global economy. He first addressing the contradiction in foreign aid policy in developed countries. Metcalfe points out that, although the United Nations has put forth the incredibly ambitious Millennium Development Goals, which include halving extreme poverty rates and halting the spread of HIV/AIDS by 2015, the ratio of foreign aid to national GDP of developed countries has stagnated around 0.35%, even though aid targets remain at 0.7% of GDP. He asserts that foreign aid payments have also dropped since the financial crisis, and that progress towards our ambitious development goals will remain slow if this problem is not properly addressed. His solution? Simply print money for foreign aid.

At the basis of Metcalfe’s idea is the suggestion that the money supply doesn’t affect inflation as drastically as many believe. He explains that despite the U.S. Federal Reserve’s multi-trilion dollar asset purchasing program, the inflation rate in the U.S. has remained relatively unaffected 6 years later. Indeed, if we use the Consumer Price Index as a strong proxy for annual inflation in the U.S., then it does appear that the price level, apart from a small and temporary increase during the recession, hasn’t dramatically risen since the financial crisis. Screen Shot 2014-04-05 at 9.19.05 PMBuilding the foundation of his argument upon this information, Metcalfe asserts that we should take a fraction of the money that was printed to stimulate the economy and send it to countries who rely on foreign aid. Like a firm that matches the charitable donations of its employees, the U.S. central government could encourage the Federal Reserve to match its contributions to its annual foreign aid payments. Furthermore, since these payments would be going overseas, he explains that it’s not obvious how this form of funding would directly contribute to inflation in the central bank’s home country. According to Metcalfe, this could dramatically increase the amount of foreign aid payments to developing countries with limited risk to creating inflation and smaller requirements from the central government’s coffers.

At first glance this looks like a very interesting idea, and one that seems certain to garner praise. I mean, who wouldn’t want to eliminate eliminate global poverty with a few keystrokes from the FED? On the other hand, there do appear to be a few inconsistencies with his logic and methods that could prove problematic. First, I would be careful not to make the assumption that just because inflation didn’t appear to increase much after QE, that printing money doesn’t cause high levels of inflation. While it is true that the central banks of the U.S., UK, and Japan created around $3.7 trillion to help push the global economy out of a recession, that doesn’t mean that all of this money made it out into the economy. As we’ve all learned in Econ 102, the Federal Reserve adjusts the money supply though Open Market Operations, in which it buys securities from national banks. These banks are then supposed to take this newfound money and loan it out to individuals, whereupon it the money will have a multiplicative effect after individuals deposit their loans in other banks, who lend out a share of this money to other individuals, who deposit it in other banks, so on and so forth. A problem occurs, however, when banks decide not to lend money to individuals. This was an apparent phenomenon during the financial crisis when banks decided to hold on to the Fed’s newly invented money in in fears of the risk of financial collapse. We actually see there is a steep decline in the number of loans make by commercial banks after the financial crisis, so not all the money created by the fed actually entered the U.S. economy. Therefore, it’s not fair to use the Fed’s dramatic monetary policy and subsequent small blip in price levels during the recession as evidence that we could simply print money for aid without affecting inflationScreen Shot 2014-04-05 at 10.25.44 PM

 

It seems surprising that a senior managing director and supposed global macroeconomic expert would make such a statement based on shaky evidence, so perhaps he is more privy to the more quantitative effects of QE on inflation than he lets on in his talk (he only has 15 minutes after all). Regardless, I would also contend that his strategy may also fail on practical terms as well.

Let’s assume that hypothetically the Fed liked this idea and wanted to enact this as part of its monetary policy. In order to make the donation, the Fed would have to enact open market operations in foreign countries by buying up bonds from central banks (or, if absent, the central government) in developing countries. While the Fed might expect that the banks would lend this money out to the citizens, thus stimulating the local economy, this may backfire given higher levels of corruption in these developing countries (corrupt and ineffective governments are often the reason why many countries remain in the “third world”). Many of the most impoverished countries do also score highest on indices of political corruption, such as Sudan and Haiti. These banks and governments may in some cases decide to shower the money upon themselves, leaving the citizens still impoverished. Furthermore, government debt in third world countries is likely to be far riskier than in developed countries, and the bonds are likely to become worthless. Therefore, it would be unlikely that the Fed could effectively channel foreign aid to developing countries and find the money reaching those that need it most.

Overall, it appears that there may be some large problems in Mr. Metcalfe’s solution to the foreign aid gap that would have to addressed before this could become feasible government policy. 

 

Japan Boosts Sales Tax, May Test Abe’s Policies

Japanese citizens across the country have been rushing to the malls and supermarkets ahead of the sales tax increase this Tuesday. According to George Nishiyama of the Wall Street Journal, Japan plans to implement a sales tax increase from 5% to 8%, which was designed to help pay for the nation’s exploding social welfare costs and public debt. It is expected that citizens will begin to rein in their spending habits after the tax increase, which appears to contradict Prime Minister Abe’s plan to stimulate the economy. As Nishiyama points out, in 1997, the last time Japan initiated a sales tax increase from 3% to 5%, Japan ended up plunging into a recession lasting 18 months. He also points to a poll by the Kyodo new agency that suggests that

“66% of respondents plan to cut spending, while 33% said they don’t plan any changes. Nearly 80% expressed worry about the economic outlook.”

Overall, Nishiyama seems to suggest that the sales tax rise may be dangerous, in that it could contribute to factors leading to a failure by Abenomics to lift the economy, which in his words “has already faced criticism that it is a policy of exiting deflation by creating a bubble through easy money at the expense of ordinary Japanese.”

Whether this was a causal relationship is yet to be seen, but in any case it seems as though there may be unforeseen consequences of issuing sales tax increase is arriving at the wrong time, and, on one hand, that it has the potential to weaken Abe’s efforts to boost the Japanese economy.

On the other hand, the Economist appears more impartial than the Wall Street Journal to the idea of the sales tax increase, considering fiscal consolidation over the longer term a “fourth dart in the quiver” against Japan’s anticipated financial woes. According to the Economist, Japan’s national public debt issue is one of them most pressing problems in the Japanese economy, as the national debt is anticipated to exceed 240% of national GDP later this year. The Liberal Democratic Party of Japan (LDP) last year cooperated with the Democratic Party of Japan (DPJ) to pass the sales-tax bill. This will reportedly increase the sales tax from 5% to 8% this April, and to 10% in October of this year. Prior to Prime Minister Abe’s inauguration, this policy initially looked like it would help get the country on track; it would reportedly cut the Japanese budget deficit to around 3.2% of GDP. This was, of course, before Prime Minister Abe’s stimulus package that would make hitting the 3.2% of GDP target improbable.

The authors don’t appear very worried about the potential negative effects of Abenomics on the  Japanese debt market. They mention that yields on Japanese government bonds (JGBs) are currently historically low, and that the market for the bonds is dominated by Japanese savers and institutions, which are more loyal and less “flighty” than foreigners who would demand high yields. This would make it less likely that there would be a rapid escape from Japanese bonds over worries that the nation could not pay its debts, and therefore may make the market more stable. Furthermore, the Bank of Japan is currently purchasing 70% of new JGBs issued annually. Essentially, much of Japan’s debt is being paid for with money that the Bank of Japan prints, that the rest is mostly in the hands of Japanese citizens, and that this is not an immediate problem. The economist also points out that while Abe’s policies may hurt Japan in the near-term, that it should boost economic activity, both raising tax revenues and making it easier for the government to raise the consumption tax.

If I were forced to pick a side, I’d stick with the Economist on this issue. First, like in many situations in Economics, it’s difficult to discern causality between events, especially one time events. This throws a bit of doubt into whether the tax increase would inevitably lead to further financial problems for the Japanese economy. The tax increase would mean that Japanese citizens would have less disposable income to spend on consumption, but Abe’s current stimulus policy may be large enough to take the edge off and could make it less likely that a subsequent recession will occur. Furthermore, it may be advantageous use the increased tax revenues to wind down the Japanese debt problem now rather than later. As another Economist article points out, the Japanese also face an aging population that in the near future will begin to withdraw money from their retirement plans. This will mean that the national savings rate could decrease in the near future and make it difficult for the Japanese government to find able citizens to buy up its debt. A tax increase now may be a proactive way to reduce this burden before things get bad. Of course, this is a contentious issue in Japanese politics, and the effects of Japan’s current policies are uncertain, so in the end it will be important for both sides to proceed cautiously.

 

Struggling PIMCO Takes Another Hit to Trailing Bond Fund

PIMCO (Pacific Investment Management Company, LLC), the global fixed income investment behemoth, has had a hard year. It’s flagship bond fund (and the world’s largest bond fund), the Pimco Total Return Fund, is currently on track this quarter to underperform 87% of its peers. As Min Zeng of the Wall Street Journal explains, the $236.5 billion fund had only a 1.28% year-on-year total return according to data from the fund tracker Morningstar. Pimco’s Total Return Fund falls well short of the standard bond benchmark, the Barclays U.S. Aggregate Bond Index, which reportedly returned 2.03% over the same period.

A number of factors have negatively impacted PIMCO’s success in the past year. In January, in a high-profile management struggle PIMCO’s chief executive Mohamed El-Erian stepped down after the firm’s bond funds stumbled and investors fled from the firm. In 2013 investors withdrew a net $41.1 billion from the Total Return fund, which was a mutual-fund industry record. The firm also appears to be riding the wrong wave, as the Fed has begun unwinding its Quantitative Easing policy, namely by decreasing U.S Treasury Bond purchases and signaling that interest rate increases are likely to arrive soon. As Jon Hilsenrath of the Wall Street Journal writes, many Fed officials believe that the central bank will increase rates soon, perhaps as soon as the end of the year. In addition, Janet Yellen, the Fed Chairwoman, has hinted that an increase in the Fed funds rate could come soon as well. Evidence of increases to interest rates has already begun to accumulate, as the U.S. Treasury yield curve, a plot of current interest rates of bonds at different maturities, has already shifted upwards in the past month. Screen Shot 2014-03-29 at 9.15.12 PMIn order to flatten out the yield curve, interest rates for 5 year and 10 year U.S. treasury bonds are increased. Since bond prices and interest rates move in opposite directions, this could be done by decreasing the price of bonds, which would occur if the Fed reduced the rate at which it purchased these bonds (demand for these bonds would go down, as would the price, and therefore the interest rate would increase). If we look at the Fed’s current holdings of U.S. Treasury bonds with yields around 10 years, we find that there is evidence that the Fed has reduced its purchases of bonds at this maturity. Here, we see the size of the Fed’s portfolio of 5-10 Year U.S Treasury bonds hasn’t changed much in the past year. Screen Shot 2014-03-29 at 9.31.29 PM

 

With interest rates set to rise, and bond prices therefore set to fall, PIMCO’s current investment manager Bill Gross is likely sweating bullets. However, Mr. Gross has weathered storms before at the helm of the Total Return fund, as he’s maintained a 5-year average annualize return of 6.9%, which is well above the benchmark’s 4.89% and above 55% of its peers. Only time will tell if Mr. Gross’s experience will be able to change the fortunes of his flagship fund in the face of turbulent bond markets ahead.

Citigroup’s Stress-Test Mess

After the most recent series of bank stress test results released by the fed this week, several banks faced greater scrutiny over their financial practices. Out of 30 banks tested, five banks, including Citigroup Inc., Zions Bancorp, and the U.S. units of HSBC Holdings PLC, the Royal Bank of Scotland Group PLC, and Banco Santander SA did not receive the FED’s approval. Citigroup Inc. in particular faced the largest setback after the Federal Reserve rejected the bank’s proposal to reward investors with higher dividends and stock buybacks. According to the Wall Street Journal, the bank’s second rejection in three years was the result of the bank’s deficiency in it’s ability to project revenue and losses under stressful scenarios in parts of the firm’s global operations. This comes even after the results showed that Citigroup’s Tier 1 common capital ratio was above regulatory thresholds, and at 6.5% above many other banks that did receive approval.As the Fed pointed out, this rejection was based on qualitative problems with the stress tests, such as with internal risk management which oversees tasks including financial risk audits and organizational risk assessment. At the end of the day, while the quantitative measures looked good on paper, the Fed did not appear satisfied with the level of safety and foresight Citigroup has shown in the past few years after the financial crisis. As a result, Citigroup and the other four banks must submit revised capital plans and suspend any increased dividend payments, the latter of which will likely cause disappointment to shareholders.

While Citigroup’s rejection certainly is not a great outcome for the bank, as it may damage its reputation and credibility as a lender and insurer. And it’s certainly an embarrassment because this recent development makes Citigroup only the second bank, aside from Ally Financial, to have its capital plan rejected twice by the Federal Reserve. But overall it isn’t necessarily a bad thing for the firm. First, the firm has a strong store of capital set aside, which could act as a buffer in case of a strong negative shock to unemployment or the stock market. Second, Citigroup’s rejection is a signal by the Fed that the firm needs to correct perceived deficiencies in its operations. Like in a first submission of an article to an academic journal, the Fed, like the peer reviewer, can send back Citigroup’s capital plan with harsh critiques, edits, and an outline of the necessary requirements. This may serve to point out potential problems in risk management or governance that Citi had previously missed. Since these problems may eventually hurt the firm down the line, if uncorrected, it’s in Citigroup’s best interest to, like an academic economist, take the critiques with a grain of salt and use them to form a plan to fix the company’s risk management. This may mean a reorganization of managers and executives, and the employees in the deficient departments may face layoffs, but if Citi can fix their deficiencies they may come out of this a healthier company.

On the other hand, the people who will face the most problems as a result of the Fed’s rejection are the shareholders (Citigroup’s stock fell 5% after hours today), and the firm’s new CEO Michael Corbat. As a consequence of Citi’s failed capital plan, it has been refused the ability to raise its dividend, which currently sits at a quarterly penny-a-share, and to engage in a share buy-back program. This doesn’t bode well for Corbat, since pleasing shareholders is one of the main goals of a modern CEO. The inability to issue a dividend means that the shareholders won’t be rewarded directly, and the inability of Citi to issue a stock buyback means that shareholders won’t enjoy the benefits of “concentrated” stocks (after a buy-back a shareholder will essentially own a larger share of the company). And the lack of confidence by the Fed in Citi’s risk procedures may make investors wary of the company in the near future, meaning that the company may face negative returns in the shortrun, which may further agitate some shareholders. Overall, this is hardly a pleasant start for the new CEO.