The 3 different waves of a business cycle.

According to Lacy Hunt, chief economist at Hoisington Investment Management the “business cycle” is actually three different waves occurring in a specific order. They peak and trough in that sequence

1. Financial cycle – lose and tight monetary policy influence the movement
2. GDP cycle – monetary policy then impact inflation and risk-taking
3. Price/labour cycle – this later makes wages and prices rise

Source: Hoisington Investment Management

Can the US Fed stimulate growth?

Although central banks can control the money supply, the velocity that it moves in an economy is very important to the business cycle – creating more money has little effect if people don’t use it. Velocity in the US is now lower than it was in the great depression. This is a serious problem for the US Federal Reserve’s attempts to stimulate growth.

There is also the problem of Marginal revenue product of debt – this is the amount of GDP growth generated by each additional dollar of debt. That has been falling for years and is set to fall even more as higher rates divert a bigger part of the revenue from debt-funded projects to interest payments instead of more productive uses.

Source: Mauldin Economics: Thoughts from the front line – 6th May 2023

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What is the shadow banking system and should it be regulated?

The main difference between traditional banking and the shadow banking system is that the latter are not subject to the same regulatory requirements that apply to traditional banks. Traditional banks in most countries are regulated by the central bank – RBNZ in New Zealand, Federal Reserve in the USA. The shadow banking sector are not structured or regulated as banks and include: investment management companies, pension funds, hedge funds, money market funds, mutual funds, payday lenders and others. However they still offer the same activities as traditional banks – loans, deposit taking etc. See graphic below from Better Markets.

Because of the fact that there is so little regulation the shadow banking sector has been growing and since the GFC in 2008 their share of global financial assets has grown form 42% to 50% by 2020. Therefore the shadow banking sector should no longer continue to be as unregulated. In the traditional banking system stringent capital and liquidity requirements as well as deposit insurance which makes them less susceptible to panic. However the recent collapse of SVB showed how poorly regulated it was and bank credit contracted $311 billion—or 1.77% in just two weeks The main concern with shadow banking is that because there is little regulation they take on more risk which means greater tendency to have less liquidity in reserve and more exposure to debt. On the flip side, shadow banks can offer a broader range of borrowing options which many industries now rely on for financing.

Source: Better Market – March 24, 2022 The Increasing Dangers of the Unregulated “Shadow Banking” Financial Sector

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The Rest is Politics podcast on the banking crisis

The Rest is Politics is a great podcast from the UK with Alistair Campbell (Downing Street Director of Communications and Strategy under UK PM Tony Blair) and Rory Stewart (ex UK Conservative Party cabinet minister). In this particular podcast Rory Stewart explains the concerns around the banking system with regard to Silicon Valley Bank, Credit Suisse and the financial instruments that nobody really understands, even the very big banks. There is mention of CDS – credit default swaps which is insurance on the bond. Also a good explanation of the relationship between interest rates and bond prices and how after the 2008 global financial crisis, regulation urged banks to put more of their money into government bonds. Remember that government bonds are seen as very secure and maintain their value. Below is the link to the podcast. The discussion on banks is from the start of the podcast to 6 minutes. Well worth subscribing to this podcast.

Banks in crisis

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Loose monetary policy not solely to blame for present economic conditions.

Martin Wolf in the FT wrote an interesting piece in the FT yesterday talking about loose monetary policy and not to wholly blame the central banks for the economic environment today. Below are some of the main points that he makes:

• Deregulation of financial markets, free trade and China joining the WTO in 2001 lowered the global inflation rate.
• Huge savings were prevalent in the global economy – especially in China and Germany
• Balance global demand and supply = big investment in housing driven by financial liberalisation.
• COVID – money growth exploded with expansionary monetary and fiscal policy.
• Fiscal deficit of G7 countries jumped by 4.6%.
• Monetary – quantitative easing and stimulatory level of interest rates
• With supply chain issues, China’s lockdown and the Ukraine War, the dramatic increase in demand could not be met by a corresponding increase in supply. See graph
• Inflation = higher interest rates = shock to banking system
• Loose monetary not the blame for what has gone wrong in the global economy
• Mistake to think that there is a simple solution to the failing of the banking systems

Things would not be wonderful if central banks had stood idly by. We cannot abolish democratic politics. Economic policy must be adapted to our world, not to the 19th century. Martin Wolf

Source: IMF

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The collapse of Silicon Valley Bank

Been covering banking and the bond market with my A2 economics class and we talked about the collapse of Silicon Valley Bank. Below is a video from the WSJ on the whole SVB saga and the history behind bank regulation under Obama but deregulation under Trump. What is interesting is the fact that 94% of SVB’s deposits (see graph) were above the $250,000 which is insured by the Federal Deposit Insurance Corporation – government corporation supplying deposit insurance to depositors in US commercial and savings banks. However you do wonder why depositors kept so much money in a bank when you would want to spread your risk. Although you may need cash for day-to-day transactions, money could be put into a market fund and brought back into a bank account when needed.

WSJ talk about bonds and below are some notes on how bond yields work. This is part of the A2 syllabus Unit 9 – interest rate determination: loanable funds theory and Keynesian theory.

How do Bond Yields work?
Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100.
100/1000 = 10%
If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the old bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return.
100/833 = 12%

—————————-

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Business cycle or volatile booms and busts? The four stages of the bubble.

I blogged on this topic last year but below is a useful video from the Wall Street Journal (WSJ) on how bubbles are so difficult to predict with some examples from Gamestop to Tulips. A graphical explanation follows after the video.

I picked up this graphic and explanation from The Geography of Transport Systems by Jean-Paul Rodrigue (2020)

It is apparent that business cycles aren’t those smooth ups and downs as depicted in a lot of textbooks but more volatile with booms and busts. Central banks appear to play their part in this process with the low cost of borrowing feeding the boom phase of the cycle. Instead of economic stability regulated by market forces, monetary intervention creates long-term instability for the sake of short-term stability.

Bubbles (financial manias) unfold in several stages, an observation that is backed up by 500 years of economic history. Each mania is obviously different, but there are always similarities; simplistically, four phases can be identified:

• Stealth – emerging opportunity for future prize appreciations of investments. Investors have better access to information and understand the wider economic context that would trigger asset inflation. Prices tend to increase but are unnoticed by the general public.
• Awareness – many investors start to notice the momentum so money starts to push prices higher. There can be sell-offs but the smart money takes this opportunity to reinforce its existing positions. The media start to notice that this boom benefits the economy.
• Mania – the public see prices going up and see this a great opportunity to invest with the expectations about future appreciation. This stage is not so much about reasoning but psychology as money pours into the market creating greater expectations and pushing prices up. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going. At some point, statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.
• Blow-off – everyone roughly at the same time realises that the situation has changed. Confidence and expectations encounter a paradigm shift, not without a phase of denial where many try to reassure the public that this is just a temporary setback. Many try to unload their assets, but takers are few; everyone is expecting further price declines. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged asset owners go bankrupt, triggering additional waves of sales. This is the time when the smart money starts acquiring assets at low prices.

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UK Pound slumps as IMF advises against tax cuts

Below is a very good video from Al Jazeera that explains the Bank of England’s emergency intervention to calm the market after the UK’s government’s tax cut plans. Once these plans were announced the GB Pound slumped to it lowest level $1.035 against the US Dollar since 1985. The BoE announced it is buying up long-dated UK government bonds to bring stability to financial markets but even higher interest rates are still likely and that is worrying news for the country’s property market. Good coverage of this below from Al Jazeera.

A2 Economics – Liquidity Preference Curve

With mock exams this week here is something on Liquidity Preference – included is a mind map that has been modified from Susan Grant’s CIE revision book.

Demand for money

TRANSACTIONS DEMAND – T – this is money used for the purchase of goods and services. The transactions demand for money is positively related to real incomes and inflation. As an individual’s income rises or as prices in the shops increase, he will have to hold more cash to carry out his everyday transactions. The quantity of nominal money demand is therefore proportional to the price level in the economy. (note:  the real demand for money is independent of the price level)

PRECAUTIONARY BALANCES – P – this is money held to cover unexpected items of expenditure. As with the transactions demand for money, it is positively correlated with real incomes and inflation.

SPECULATIVE BALANCES – S – this is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑.

If a bond has a fixed return, e.g. $10 a year. If the price of a bond is $100 this represents a 10% return. If the price of the bond is $50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

There is an inverse relationship between the rate of interest and the speculative demand for money.

The total demand for money is obtained by the summation of the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curve and is inversely related to the rate of interest.

 

 

BoJ still buying bonds as other central banks reverse asset purchases.

Within the OECD are annual inflation has been rising at an average of 9.6% – its ranges from 2.5% in Japan to 73.5% in Turkey. The US and the UK has inflation of 9.1%, Australia 6.3% and NZ 7.3%. Most of the bigger economies target a 2% inflation rate and in response to these higher rates the US Fed increased its interest rates by 75 basis points to 1.5-1.75% with a potential 50 or 75 basis point rise in July. The Reserve Bank of Australia also lifted its interest rate by 50 basis points to 1.35% in July.
In order to tackle this inflationary pressure it is normal for central banks to sell bonds / assets back into the market which is turn reduces the money supply and raises interest rates. This should depress aggregate demand as there is now less money in the circular flow and the cost of borrowing goes up. However, the Bank of Japan (BoJ) is out of kilter with accelerating interest rates as it has committed to its policy of yield curve control intended to keep yields on 10-year bonds below 0.25% by buying as much public debt as is required – see graph below:

FT – Investors crank up bets on BoJ surrendering yield curve controls

How to Bond Yields work?
Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100.
100/1000 = 10%
If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the new bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return.
100/833 = 12%

Yield curve control
Yield curve control (YCC) involves the BOJ targeting a longer-term interest rate by buying as many bonds as necessary to hit that rate target. It has been buying Japanese Government Bonds (JGB) at a monthly rate of ¥20trn which is double its previous peak of bond buying in 2016. Although there is no theoretical limit on its buying ability it has impacted the currency which has fallen to a 24 year low against the US dollar. This will push up the price of imports and inflation although the BOJ is confident that the price rises in its economy are transitory. If inflation does start to consistently hit levels above the BOJ’s target of 2% will they reverse their bond purchasing policy and shift to a higher yield cap?

Shorting JGB’s
A lot of investment banks are looking to short JGB’s. In this situation the trader suspects that bond prices will fall, and wishes to take advantage of that bearish sentiment—for instance, if interest rates are expected to rise. This will likely happen if the Japanese relax their YCC with interest rates rising and bond prices falling – see image below for a simple explanation of shorting.

Source: Online Trading Academy

Sources:

• The Economist: – BoJ v the markets. June 25th 2022.
• Financial Times: Investors crank up bets on BoJ surrendering yield curve controls. June 23rd 2022

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Crowd Psychology and the Stock Market

Anatole Kaletsky wrote an article in Gavekal Research – ‘Five Features Of Market Madness’ – (Ideas June 16 2020) in which he talked about ‘Nominative determinism’. Two examples:

1. Chinese property company called Fangdd Network where its value jumped from US$800mn to US$10bn in four hours of trading. Fangdd Network made it sound like a cheap ETF (ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually) for the FAANG technology giants.
2. Nikola, an aspiring electric vehicle manufacturer with no revenues that launched three months ago on Nasdaq saw its value spike to almost US$30bn, up from US$300mn at its March IPO, mainly because, like Elon Musk’s electric car company, it was also named after 19th century Serbian-American inventor Nikola Tesla.

Anatole Kaletsky 5 features of market madness

• While monetary easing usually starts a bubble, a reversal in monetary policy is unlikely to deflate the bubble once the speculative momentum builds.
• Valuations do not matter while a bubble is inflating, but they become very important after it bursts.
• Bubbles typically end with the some huge corporate collapses (Charles’s analogy of dynamite fishing), often tainted with fraud.
• Bubble dynamics need not bear any relation to the strength, or weakness, of the economic cycle.
• Speculation increases dramatically when prices break through major highs.

These examples show that it is not analysis of valuations, monetary policy or economic data that is driving prices up. Famous economist J.K. Galbraith once remarked that ‘economic forecasting was invented to make astrology look respectable’. He also said that we are mush reassured by the ‘conventional wisdom – i.e. strongly held beliefs that have, at best, a tenuous grounding in reality. John Maynard Keynes stated that ‘the market can stay irrational longer than you can stay solvent’. Mervyn King, former Governor of the Bank of England, argues that economic decisions always occur under conditions of, what he calls, ‘radical uncertainty’ – unaware of what might happen in the future. King says that people use ‘narratives’ to make sense of the world. He also suggest that economists in the 2008 GFC didn’t learn from history – the Great Depression before they were born.Each time they suggest that this time it is different – an expression by experts suggesting that the new situation (GFC) bears little resemblance to previous crises. Carmen Reinhart and Kenneth Rogoff in their book entitled ‘This Time is Different’ show that we haven’t learnt from what happened in the past – short memories make it all too easy for crises to recur.

Quantitative Easing – put your printer by the window and press Enter.

Doing quantitative easing (QE) with my A2 class last period today and showed a humourous video with the late John Clarke about ‘What is Quantatitive Easing?’ – Point your printer out the window and make sure the wind is blowing in the right direction. Below is an explanation but Clarke and Dawe have an interesting take on it.

Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. Governments and central banks like there to be “just enough” growth in an economy – not too much that could lead to inflation getting out of control, but not too little that there is stagnation. Their aim is the so-called “Goldilocks economy” – not too hot, but not too cold. One of the main tools they have to control growth is raising or lowering interest rates. Lower interest rates encourage people or companies to spend money, rather than save.

But when interest rates are almost at zero, central banks need to adopt different tactics – such as pumping money directly into the economy. This process is known as quantitative easing or QE.

New Zealand’s interest up 25 basis points but is it still stimulatory?

Today, not surprisingly, the RBNZ increased the official cash rate (OCR) by 25 basis points – 0.25% – to 1%. There was a suggestion in the RBNZ Monetary Statement that the increase could be 50 basis points but noted a preparedness to move in bigger steps than 25bp “if required”. The RBNZ forecast endpoint for the OCR has been increased to 3.35%. and expect annual CPI inflation to peak at 6.6% in the March 2022 year and to fall back to the 1-3% inflation midpoint by mid 2024. The reduction in inflation should come from the easing of supply chain disruptions, lower commodity prices and tradable inflation. But the question that needs to be asked is, will this tightening be sufficient to dampen the following:

• domestic pressure from the housing market,
• wage pressure with 5.9% inflation and unemployment at a very low 3.2%,
• prices of locally produced products (non-tradable inflation)
  

The Neutral Interest Rate

Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.

The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.

OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy

The RBNZ’s  estimate of the neutral OCR is between 0.9% and 3.1% – see below.  Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.

Since the GFC neutral rates around the world have been falling which reflects the following:

1.  Lower expectations about growth in the economy = reduces the return to investment
2.  Relative to pre-GFC, a wider spread between the central bank rate and the interest rates faced by households and businesses (i.e. mortgages and business lending rates).
3. An increase in global desired savings. For instance, demographic trends offshore have led to an increase in saving among the cohort of the population going through prime earning years (as they save for retirement). Likewise, increased income inequality is thought to increase desired savings, as top income earners typically have a lower marginal propensity to consume – MPC.
4. Higher debt ratios in some countries (including NZ) make the economy more sensitive to interest rate increases than before.

Central Banks don’t have the independence to set the neutral rate as it is very much influenced by global forces. However they do have independence as to where they set their policy rate relative to the neutral rate.

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What is ‘Value’ in an economy?

I read a review (from Palladium Governance Futurism) of Mariana Mazzucato’s book ‘The Value of Everything : Making and Taking in the Global Economy’ in which she challenges the view of what ‘value’ is in an economy. She refers to ex Goldman Sachs CEO Lloyd Blankfein’s quote

‘The people of Goldman Sachs are among the most productive in the world.’

Goldman Sachs was one of the many investment banks that had to be bailed out after the GFC but how do we value their productivity?

Privatise reward and socialise risk
It seems that the investment banks were happy to privatise the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008. For a lot of these companies a large payout is a sign of success in that they are too big to fail and leave the government no alternative. However where is the value generation from this?

Value – historical perspective

• French physiocrats – value was produced from the land
• Adam Smith – saw landlords as rentier class
• Marx – labour is the source of value

Today economics is more focused on a subjective, utility-focused approach and therefore sidestepping the historic debate about value which is undermining the discipline of economics. This new approach, according to Mazzucato, has weakened neoliberal economies to innovate. Key to understanding the the value debate is what is considered production in our GDP. The informal economy is a part of all economies but is not included in the national accounts. As is someone building their own house. So what is considered to be real wealth/value? Rather than focusing on how wealth was created and what counted as wealth, economists began to ask how utility was satisfied on the margin. This allowed for the mathematical approaches to be used in modern economics.

Thomas Aquinas stressed the need for a ‘just price’. It was immoral for a supplier to raise his price when consumers are in great need of a specific good (inelastic demand). The price should cover the cost of production and the maintenance of the worker and his family. Today value is in the eye of the consumer and price, in turn, reflects utility gained by a consumer from an additional unit go goods or services.

Finance and productive value

Finance’s case is founded on the notion that it is a necessary part of production by allocating capital to businesses. However Banks direct their revenues into interest payments and the share price. This fuels speculative bubbles which are refinanced through the securitisation food chain and therefore inflating assets without investment.

Australian bank Macquarie acquired utility company Thames Water – increased its debt to US$10.05 bn over 6 years, therefore leveraging the privatised assets they had acquired into increasing debt. By doing this they saved their own revenues for interest payments and shareholder distributions – hard to make the case for privatising public assets. Mazzucato also points out that since the GFC the finance sector has focused on debt deflation and unemployment and wage reduction so corporate profits could be maintained at the expense of employee earnings. So the financial sector continues to make contributions to GDP in the money it generates but firms in the tech sector and natural resources can’t contribute to the money supply the way commercial banks can, and can’t easily hedge parts of the economy.

The book also gives examples of factors that contribute to GDP but they don’t actually produce anything.

• Ford – 2000’s – they made more money from selling loans for cars than by selling cars themselves
• General Electric – finance arm of the business made around 50% of the whole group’s earnings.

On a more positive side Welsh Water was a company with the lowest ratio of debt to equity and the highest credit rating. It is mutually owned and operated as a not-for-profit operation.

Two great myths – Innovation and Public Sector

She points out that the world’s biggest companies have built themselves on the legacy of state backed, publicly funded innovation. EG:

• Nearly all major parts on smartphones were developed in university-based research facilities using public money.
• Defence Advanced Research Projects Agency – developed the Internet and SIRI
• US Navy – GPS system used by phones and computers.
• National Science Foundation grant – created the algorithm behind Google.
• Pharmaceutical drugs – 2/3 of the most innovative drugs trace their research to funding by the US National Institutes of Health.

Final thought

Keynes was seen as the last supporter of government investment. He recommended state intervention during downturns in order to stimulate growth and spending. This intervention is intended to shock the economy into greater output

According to Mazzucato the public sector is the true creator of economic value – value which could not just be created by private counterparts. Vital to this is the rebuilding of the public sector’s funding for innovation. Her clear goal is that economists and governments alike to cease viewing value as a purely subjective and individualistic measure.

Doc Martens – from anti-capitalist punk movement to London Stock Exchange

In the 1970’s Doc Marten boots were a symbol of youth culture, inner rebellion and an essential part of the uniform. However last week the company floated on the London Stock Exchange which sort of sums up the unequal environment that we live in as it seems that everything can be repackaged, commodified and resold – e.g. US housing market and subprime mortgages.

The story of Doc Martens is the story of the financialisation of the global economy. It is a tale of credit cycles, access to capital and a winner-takes-all form of capitalism that undermines our social fabric. The story is a microcosm of much that is problematic with late-stage, 21st-century financial engineering. Some key points about the financialisation of Doc Martens:

• 1945 -Klaus Märtens a doctor in the German army injured his ankle whole skiing. Designs a better boot.
• 1947 – now with investor partner Herbert Funck they start to make good sales
• 1959 – R. Griggs group Ltd (UK shoe manufacturer) bought patent rights
• 2013 – Griggs family sell the company to private equity company Permira for £300 million
• 2021 – Permira plans to float Doc Martens at a valuation of $4 billion.

The advantage to firms like Permira is that they can borrow money at virtually 0% interest and deals like this normally involve a small amount of equity, carrying a significant amount of debt.

This means that if the debt-to-equity ratio of the original deal was 90/10, the return on committed equity could be more than 100 times the original cash investment. It is not difficult to see why, at times of very low interest rates, the return to the already wealthy and financially literate goes through the roof. Financial engineering that benefits the extremely rich, converts an everyday shoe company into a gold mine. (We are talking Doc Martens here, not a life-saving Covid vaccine.) David McWilliams

Inequality statistics from the USA:

• Top 10 per cent of wealthiest families in the US hold 76 per cent of total household wealth.
• Bottom 50 per cent held just 1 per cent of the nation’s wealth.
• Top 1 per cent of families account for 40 per cent of all wealth.
• Between 1979 & 2015, households in the top 1 per cent saw their incomes grow five times as fast as the bottom 90 per cent,
• Earnings of the top 0.1 per cent grew 15-times faster than the bottom 90 per cent.

In 1941, US supreme court justice Louis Brandeis noted: “We can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can’t have both.”

Source: What a Doc Martens boot can teach us about the wealth gap

The Pound, the Exchange Rate Mechanism (ERM) and George Soros pockets $1bn

Teaching  exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM). The video below explains the drama that unfolded very well.

Background

The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in relation to one another.

It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation

Black Wednesday

Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.

Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.

* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.

Short-selling explained – ‘Trading Places’ movie

The 1983 movie ‘Trading Places’, staring Eddie Murphy and Dan Aykroyd tells the story of an upper class commodities broker Louis Winthorpe III (Aykroyd) and a homeless street hustler Billy Ray Valentine (Murphy) whose lives cross paths when they are unknowingly made part of an elaborate bet.

There is a great part in the movie when they are on the commodities trading floor that explains price and scarcity. Winthorpe and Valentine are up against the Duke Brothers in the Frozen Concentrated Orange Juice (FCOJ) futures market.

How a futures market works
As opposed to traditional stock/shares futures contracts can be sold even when the seller doesn’t hold any of the commodity. For instance a contract of $1.30 per pound for a 1000 pounds of FCOJ in February indicates that the seller is compelled to provide the produce at that time and the buyer is compelled to buy the produce.

Here’s how it worked in the movie
The Duke Brothers believe they have inside knowledge about the crop report for the orange harvest over the coming year. They are under the impression that the report will state the harvest will be down on expectations which will necessitate greater demand for stockpiling FCOJ – this will mean more demand and a higher price. Therefore at the start of trading the Dukes representative keeps buying FCOJ futures. Others saw they were only buying and wanted in on the action, those that had futures were not willing to sell so the price kept rising. However the report was fake and Winthorpe and Valentine had access to the genuine report which stated that the orange harvest had not been affected by adverse weather conditions. Knowing this they wait till the the price of FCOJ reaches $1.42 and start to sell future contracts.

Then when the crop report is announced and it indicates a good harvest investors sell their contracts and the price drops very quickly. The Dukes are unable to sell their overpriced contracts and are therefore obliged to buy millions of units of FCOJ at a price which exceeds greatly the price which they can sell them for. In the meantime Winthorpe and Valentine for every unit they sold at $1.42 they only have to pay $0.29 to buy it back to fulfill their obligation. This results in a profit of $1.13 per unit.

A2 Economics – Credit Multiplier

When a bank accepts or collects deposits they keep some of the deposit as reserves (0.r is the reserve ratio) and advance the rest. As this money is spent it comes back into the banking system as someone else’s deposits. Some of this new deposit is kept as reserves and the rest advanced. This process continues until the new deposit becomes so small it can be ignored.

The value credit creation multiplier is an indicator of the final change in bank deposits which will stem from the initial change. We can calculate this as 1 / 0.r, where 0.r is the reserve ratio.

In the example below the credit creation multiplier equals 4 (that is, 1 / 0.25). Further we can work out the growth in the money supply (eventual increase in money supply), using the following formula: Eventual increase equals 1 / 0.r multiplied by the initial deposit in the money supply. In our example it is 4 times $100m equals $400m. The example below shows that loans given by one bank then become a deposit in another bank. Of that $75m deposited 25% must be kept in reserve ($18.75) and the remainder can be lent out ($56.25). This process continues through the banking system. We can also calculate the secondary expansion or credit created using this formula: Credit created equals (1 / 0.r multiplied by the initial deposit) minus the initial deposit.In our example it is $400m – $100m equals $300m.

The change in the money supply may not be as high as calculated because of leakages or withdrawals from the credit creation process. Banks tend to lose reserves as the public will not deposit the whole of the loans back. The public may retain some of the loan in the form of cash, or banks may be unable to find creditworthy customers to make advances to, or funds may get diverted into government securities.

Reserves may also be lost to taxation and imports (under a fixed exchange rate). The reasons for the initial increase in bank reserves could be the public banking more notes and coins than they withdraw, or public debt maturing. If a Central Bank buys back (purchases) government securities or other financial assets from the public or financial institutions, then there will be an increase in bank reserves.

Read more at: elearn Economics

Credit rating agencies polices could impact developing countries recovery.

The world’s three major private credit-rating agencies (CRA) Standard & Poor’s, Moody’s and Fitch are using their power to prevent low-income countries from restructuring their debts and stimulating their economies. Credit rating agencies realise that developing economies who engage with private creditors, which is part of the G20 Common Framework for Debt Treatments, run the risk that those creditors will incur losses and therefore CRA downgrade the developing country’s credit rating. The Common Framework is supposed to help debt-ridden countries and are the best chance for developing countries to reduce their liabilities but a ratings downgrading damage their prospects.

Standard & Poor’s, Moody’s and Fitch control more than 94% of outstanding credit ratings. They are basically an oligopoly influencing financial portfolio investments, the pricing of debt and the cost of capital. Their authority is also enhanced by the SEC (Security and Exchange Commission) who see them as the official CRA. Below are the ratings that each company uses.

We’ve been here before – conflict of Interest and the sub-prime crisis of 2008
Rating agencies are paid by the people whose products they grade and they are competing against other rating agencies for the business. Subsequently the rating agencies were being played-off against each other by the bankers in this market and this led to a systemic decline in standards and willingness not to check the underlying information as thoroughly as possible for fear of losing the deal. Even the rating agencies themselves admit mistakes were made is assessing sub-prime debt and that there were issues to do with data quality from their sources of research. However one has to consider whether the world have been better off if credit rating agencies had not existed as pension funds, bond funds, insurance companies etc would have had to do a lot more of their own research on what they were buying.

Remember before the credit crisis AAA investments mushroomed between 2000-2006 see graph below.

But consider the following:
Bear Stearns – rated A2 a month before it went bankrupt
Lehman Brothers – rated A2 just days before it collapsed
AIG – rated AA within days of being bailed out
Fannie Mae & Freddie Mac – AAA rating before being bailed out by the government
Citigroup – A2 before receiving a bail out package from the Government
Merrill Lynch – A2 before being sold to Bank of America

A2 is considered a good investment grade

Source: Credit-Rating Agencies Could Derail Economic Recovery – Project Syndicate

Financial Crisis and Political Upheaval in Nazi Germany

A recent paper by Sebastian Doerr, Stefan Gissler, José-Luis Peydró and Hans-Joachim Voth investigates the role that a financial crisis in Germany played in the Nazis coming to power. They show how financial distress can lead to radical voting when accompanied by a convergence of cultural and economic factors. In less than four years, the Nazis went from capturing 2.6% to 37.3% of the popular vote. The authors identified the failure of one bank as being significant in growing the support of the nazis – Danatbank.

Danatbank and Dresdner Bank
Danatbank (the second largest bank in Germany) was widely seen as responsible for causing the financial crisis, and it was headed by the well-known Jewish manager Jakob Goldschmidt, a favourite target of Nazi propaganda. Its collapse in 1931 saw a surge of support for Hitler. Dresdner Bank, Germany’s third-largest lender, failed as well. Exposure to Dresdner Bank had a similar negative effect on city incomes as exposure to Danat, but had almost no effect on support for the Nazis. By contrast, Dresdner Bank was not the key target for Nazi propaganda – even if it had numerous Jews occupying leading positions like most German banks. While the economic impact of the two bank failures was almost identical, only exposure to Danat had a significant effect on Nazi voting. By 1932 Danatbank and Dresdner Bank merged.

Note: The shaded area indicates the period of the 1931 banking crisis, from the beginning of troubles at Austrian Creditanstalt to the merger between Danatbank and Dresdner Bank. Blue vertical lines show: (A) beginning troubles at Austrian Creditanstalt (May 1931), (B) Nordwolle accounting irregularities discovered and Hoover Moratorium established (June 1931), (C) failure of Danatbank and ensuing bank holidays (July 1931), and (D) forced merger of Danatbank and Dresdner Bank. 

The Depression enabled the Nazis’ rise to power, but the financial collapse of 1931 thus lent seeming plausibility to a key Nazi hate narrative, helping to bring a large part of the German middle class round to the party’s world view.

Wall Street and Main Street – the disconnect.

Excellent video from The Economist regarding the disconnect between Wall Street and Main Street i.e. Stock Market and the Economy. The S&P 500 is up 38% since the middle of March this year when the US economy has been going through one of its worst recessions. The US Federal Reserve had a role here by providing aid packages so the increase in the S&P was seen as a Fed rally and not from normal fundamentals.