This was no love at first sight. It took me eight months after the launch of the iPhone to be talked into joining the world of “Phonies.” Launched (almost presciently) right before the subprime crisis hit last summer, the iPhone for me captured the essence of an era soon to end: Carefree, contented, insatiable.
Then, one day, as I took out my aging Samsung freebie to answer a call, a friend looked at me with awe: “This is no match for a Chevelle!” I was forced to agree by the voting majority at our table, so soon enough I was in search of alternatives.
No meticulous research was needed to conclude that a Blackberry would not be my optimal consumer solution:
“It’s sooo ‘matches-my-golf-clubs!’” was my friend’s verdict.
So left with no choice, I rushed to my local Apple store to buy the iPhone, no questions asked… but for the obvious: “How much?”
“Three-ninety-nine, no, no introductory discount, and do take a look at the accessories!”
Four hundred bucks for a phone!!??…
Economists have a measure of the satisfaction we draw from consuming: It’s called the “consumer surplus.” The idea is very simple: We measure your pleasure of consuming something by looking at how much you are prepared to pay for it. For example, however outrageous the thought of spending $400 for (the perfect!) match to my nom de plume, I did go ahead and paid it… therefore, I must believe my “iPhone experience” is worth at least as much.
Specifically, the consumer surplus is the difference between the maximum price consumers are willing to pay for, say, an iPhone (their reservation price), and what they actually end up paying (the market price). So suppose you are a gadget freak, with your sense of identity seriously compromised unless you own the latest item in gizmo-land. Then, your consumer surplus from owning an iPhone is tremendous: Four hundred bucks just looks like a great bargain!
But if you think that a phone is a phone, then you’ll likely come out of the Apple store like I did: Beset by a feeling that Apple has just squeezed out of you every single drop of your potential consumer surplus.
Of course, that’s precisely what companies would ideally love to do: Squeeze out the entire consumer surplus from every consumer. But this is not easy: It requires that they be able to identify each consumer’s type—e.g. “gadget addict” or “functional bore?”—and charge accordingly. That’s the logic behind “price discrimination.”
And while we have yet to see price discrimination in iPhones, airlines, for example, do it all the time: They charge different prices in order to extract as much consumer surplus as possible from different target groups: So… Are you an organized, middle-income traveler with a flexible schedule and a “prudent” wallet? Great, you can get cheap tickets by planning your holiday way in advance. But what if you’re that type who suddenly remembers your best friend’s wedding is in Vegas… next weekend?! Rest assured, the airline will smell your sense of urgency and price it appropriately.
Apart from your lifestyle preferences, companies will look at other factors in their “mission” to extract your consumer surplus. Your income, for example: Whether you think the iPhone “deserves” 800 bucks is irrelevant, if you can’t afford it. Going back to the airline example, business versus economy tickets is an obvious case of price discrimination driven by travelers' (or their companies') affordability (on top of the need for utmost flexibility and a flat bed).
In addition, your consumer surplus also depends on how “inelastic” your demand is. If you really can’t do without an iPhone, if life has no meaning if you can’t zoom in and out Angelina’s face with your fingertips, you’ll just buy it no matter the price—your demand is perfectly inelastic and your pleasure from the iPhone… infinite!
This will be particularly the case if there are no obvious substitutes for the product in question. What... you said the Blackberry? Look at it! So many buttons, yet none for the weather! And no room for your playlists! And then it’s also so corporate, so secure, SO… reliable!!
Not long after my purchase, my consumer “surplus” turned negative: I mean, what’s the use of a multi-touch screen display if touching the “Send” button is no guarantee for having your emails delivered? So I rushed back to the Apple store ready to throw the device at their face and demand my money back.
“Email? That’s not the iPhone’s forte”, said a store assistant, almost stunned with my complaint.
He found support from that same friend of mine, who had accompanied me, always dying for an excuse to visit an Apple store. “Your iPhone is a lifestyle statement. Sleek, professional, playful. And so what if, from time to time, an email fails and you come across as a disorganized, chaotic diva? Oh, and you do need a protective cover for it.”
Soon after, I was out of the store, iPhone still at hand, wrapped in a fluorescent yellow rubber case—at $29.95 plus tax. My reservation price for being able to find my iPhone in my… disorganized, chaotic handbag.
Glossary: consumer surplus, reservation price, price discrimination, inelastic demand, multi-touch screen display
Sunday, June 1, 2008
Consumer Squeeze
Monday, May 26, 2008
Party TIPS
If you’ve run out of ideas for party pick-up lines, try this:
“Hey precious… how much do you think prices will go up or down over the next 12 months?”
In case you’re dying to ask, I did try it. And, trust me, you’re guaranteed to get at least a few stares!
What you may also get is some spooky numbers. “One percent” said someone (hello? what world are you living in??). Another offered (an obscurely specific) 12.73 percent. True, some of the respondents were either pulling my leg or were already pretty drunk. So let’s discard the “outliers” and stick to the middle ground. The middle response (or median) was near 5 percent. That’s one percent higher than current inflation, which tells me that people expect prices can only go higher… and faster.
Anchors or spirals? Accurate or not, inflation expectations are an important input in the Fed’s decision-making process when it comes to setting interest rates. What the Fed cares about is that people’s expectations of inflation in the medium term remain “well anchored.” “Anchored” as in “relatively insensitive to news about the economy.” Why does this matter?
It matters because it has implications for actual inflation.
Let’s say for example that you’re flipping the TV channels and you hear that gas prices have shot up to nearly $4 a gallon. If your inflation expectations are “well anchored,” you’ll most likely yawn and continue flipping. For a moment, it might even cross your mind to postpone that summer road trip for next year: “Surely the surge is temporary,” you think. Or… “No big deal, the prices of other things will go down, as people spend more on gas and less on everything else.” Or.. “No matter what, the Fed is bound to do something about it!”
Now guess what will happen if your expectations are not “anchored”: Right, you (and your union) go to your respective bosses and demand a pay-rise. Bosses eventually bow to the pressure and your wages go up. But now companies’ wage costs have increased—so they decide to raise their prices even further—a vicious wage-price spiral!
This is exactly what the Fed wants to avoid. And in recent years it has been pretty successful in doing so. But is this about to change?
A penny for your thoughts: There is no shortage of indicators that try to gauge people’s expectations about inflation. Some are based on surveys with questions similar to my party pick-up line—though, admittedly, a tad more rigorous! What they tell us is a story that sounds spooky enough to catch the Fed’s ear.
Take for example the survey conducted by the University of Michigan. It shows that consumers now expect inflation in five years time to be around 3.3 percent. Hey, did I see you yawn? Fine, it’s not “scary-high” but it’s the highest it has been in more than a decade. Moreover, when it comes to short-run inflation expectations (over the next 12 months), these have arguably entered the “frightening” territory: At 5.2 percent, expected inflation is the highest since the early 1980s!
We also have the Survey of Professional Forecasters conducted by the Philadelphia Federal Reserve. “Professional” as in “(supposedly) better informed about prices, by virtue of their profession” (like Wall Street economists!). Once again, we have an increase in inflation expectations in recent months, though at levels that sound more benign—2.7 percent for inflation next year.
How much should we trust these people? I mean, they could well be drunk while the were answering the survey.. or incensed after having just filled up their gas tank.. or, simply, prone to error. Indeed, a historical comparison between the inflation expected in those surveys and actual inflation, points to frequent errors—positive or negative.
Put your money where your mouth is: There is also another indicator of expected inflation that the Fed looks at. That’s the inflation derived by comparing the yield of standard government bonds with the yield of government bonds that protect investors from inflation—the so-called TIPS (or Treasury Inflation-Protected Securities).
The idea behind TIPS is the following: Suppose I invest my money today in the usual (“nominal”) Treasuries, maturing, say, in five years. I then receive a fixed interest every six months and, after 5 years, I also get my principal back. This fixed interest rate will reflect investors’ expectations today for inflation over this five-year period: The higher the expected inflation, the more the interest investors demand, to keep their savings from eroding.
But what if inflation goes up unexpectedly? Yeap, I’m sc$&#*d… the (fixed) interest I receive will not compensate me enough for inflation and my savings will buy less “stuff” five years down the road. TIPS, on the other hand, offer protection against inflation by adjusting my returns every time inflation changes.
So, in principle, the difference between the yield of nominal treasuries and the yield on the TIPS (of the same maturity) should be equal to the market’s expectation of inflation. And since traders bet (a lot of) money into these securities, you would expect the calculation to give us the market’s best guess about future inflation.
Now, in practice, this simple subtraction does not give a clean-cut measure of inflation expectations (if you’re curious why, see here). So the Fed actually makes a couple of adjustments to make sure that apples are compared with apples.
So what do TIPS tell us? The “quick and dirty”, simple-subtraction approach shows that inflation expectations have remained remarkably stable over the past few months. Kind of weird, right? With oil prices double their levels a year ago, and other commodities rising at double digits, you wonder what on earth is going on in traders’ minds… Are they numb? Or do they foresee a calamitous collapse of the economy that will force prices down? But you may not have to go that far. If you see the inflation expectations derived after the adjustments I was talking about, there has been a clear upward move since late last year.
So… what’s happening? Are people losing trust in the Fed? Are we going to start seeing vicious wage-price spirals? Or should we brace ourselves for interest rate increases by the Fed later in the year?
Reading their signals: Truth is, when it comes to the link between inflation expectations and actual inflation, there are still too many question marks for the former to guide policy in a definitive way: For example, how do we, (economic) agents, form our inflation expectations? How exactly do people’s expectations respond to monetary policy? And, actually, are inflation expectations a good predictor of realized future inflation? The understanding of all these issues is evolving, yet far from perfect.
Importantly, the Fed continues to care quite a bit about employment and growth. And with house prices still looking for a bottom, the situation in the labor market fuzzy and credit markets on “ER” mode, controlling inflation expectations might look like a lesser priority--at least as long as the Fed continues to think (/wish) that commodity prices will “level off”... and that you'll keep on yawning.
Glossary: inflation expectations, TIPS, median, anchors, spirals.
“Hey precious… how much do you think prices will go up or down over the next 12 months?”
In case you’re dying to ask, I did try it. And, trust me, you’re guaranteed to get at least a few stares!
What you may also get is some spooky numbers. “One percent” said someone (hello? what world are you living in??). Another offered (an obscurely specific) 12.73 percent. True, some of the respondents were either pulling my leg or were already pretty drunk. So let’s discard the “outliers” and stick to the middle ground. The middle response (or median) was near 5 percent. That’s one percent higher than current inflation, which tells me that people expect prices can only go higher… and faster.
Anchors or spirals? Accurate or not, inflation expectations are an important input in the Fed’s decision-making process when it comes to setting interest rates. What the Fed cares about is that people’s expectations of inflation in the medium term remain “well anchored.” “Anchored” as in “relatively insensitive to news about the economy.” Why does this matter?
It matters because it has implications for actual inflation.
Let’s say for example that you’re flipping the TV channels and you hear that gas prices have shot up to nearly $4 a gallon. If your inflation expectations are “well anchored,” you’ll most likely yawn and continue flipping. For a moment, it might even cross your mind to postpone that summer road trip for next year: “Surely the surge is temporary,” you think. Or… “No big deal, the prices of other things will go down, as people spend more on gas and less on everything else.” Or.. “No matter what, the Fed is bound to do something about it!”
Now guess what will happen if your expectations are not “anchored”: Right, you (and your union) go to your respective bosses and demand a pay-rise. Bosses eventually bow to the pressure and your wages go up. But now companies’ wage costs have increased—so they decide to raise their prices even further—a vicious wage-price spiral!
This is exactly what the Fed wants to avoid. And in recent years it has been pretty successful in doing so. But is this about to change?
A penny for your thoughts: There is no shortage of indicators that try to gauge people’s expectations about inflation. Some are based on surveys with questions similar to my party pick-up line—though, admittedly, a tad more rigorous! What they tell us is a story that sounds spooky enough to catch the Fed’s ear.
Take for example the survey conducted by the University of Michigan. It shows that consumers now expect inflation in five years time to be around 3.3 percent. Hey, did I see you yawn? Fine, it’s not “scary-high” but it’s the highest it has been in more than a decade. Moreover, when it comes to short-run inflation expectations (over the next 12 months), these have arguably entered the “frightening” territory: At 5.2 percent, expected inflation is the highest since the early 1980s!
We also have the Survey of Professional Forecasters conducted by the Philadelphia Federal Reserve. “Professional” as in “(supposedly) better informed about prices, by virtue of their profession” (like Wall Street economists!). Once again, we have an increase in inflation expectations in recent months, though at levels that sound more benign—2.7 percent for inflation next year.
How much should we trust these people? I mean, they could well be drunk while the were answering the survey.. or incensed after having just filled up their gas tank.. or, simply, prone to error. Indeed, a historical comparison between the inflation expected in those surveys and actual inflation, points to frequent errors—positive or negative.
Put your money where your mouth is: There is also another indicator of expected inflation that the Fed looks at. That’s the inflation derived by comparing the yield of standard government bonds with the yield of government bonds that protect investors from inflation—the so-called TIPS (or Treasury Inflation-Protected Securities).
The idea behind TIPS is the following: Suppose I invest my money today in the usual (“nominal”) Treasuries, maturing, say, in five years. I then receive a fixed interest every six months and, after 5 years, I also get my principal back. This fixed interest rate will reflect investors’ expectations today for inflation over this five-year period: The higher the expected inflation, the more the interest investors demand, to keep their savings from eroding.
But what if inflation goes up unexpectedly? Yeap, I’m sc$&#*d… the (fixed) interest I receive will not compensate me enough for inflation and my savings will buy less “stuff” five years down the road. TIPS, on the other hand, offer protection against inflation by adjusting my returns every time inflation changes.
So, in principle, the difference between the yield of nominal treasuries and the yield on the TIPS (of the same maturity) should be equal to the market’s expectation of inflation. And since traders bet (a lot of) money into these securities, you would expect the calculation to give us the market’s best guess about future inflation.
Now, in practice, this simple subtraction does not give a clean-cut measure of inflation expectations (if you’re curious why, see here). So the Fed actually makes a couple of adjustments to make sure that apples are compared with apples.
So what do TIPS tell us? The “quick and dirty”, simple-subtraction approach shows that inflation expectations have remained remarkably stable over the past few months. Kind of weird, right? With oil prices double their levels a year ago, and other commodities rising at double digits, you wonder what on earth is going on in traders’ minds… Are they numb? Or do they foresee a calamitous collapse of the economy that will force prices down? But you may not have to go that far. If you see the inflation expectations derived after the adjustments I was talking about, there has been a clear upward move since late last year.
So… what’s happening? Are people losing trust in the Fed? Are we going to start seeing vicious wage-price spirals? Or should we brace ourselves for interest rate increases by the Fed later in the year?
Reading their signals: Truth is, when it comes to the link between inflation expectations and actual inflation, there are still too many question marks for the former to guide policy in a definitive way: For example, how do we, (economic) agents, form our inflation expectations? How exactly do people’s expectations respond to monetary policy? And, actually, are inflation expectations a good predictor of realized future inflation? The understanding of all these issues is evolving, yet far from perfect.
Importantly, the Fed continues to care quite a bit about employment and growth. And with house prices still looking for a bottom, the situation in the labor market fuzzy and credit markets on “ER” mode, controlling inflation expectations might look like a lesser priority--at least as long as the Fed continues to think (/wish) that commodity prices will “level off”... and that you'll keep on yawning.
Glossary: inflation expectations, TIPS, median, anchors, spirals.
Sunday, May 18, 2008
“Double, double toil and trouble…
… Fire burn, and cauldron bubble”
The three witches in Macbeth, by William Shakespeare.
At my first job, more than a decade ago, I was given the nickname “bubble.” The term was coined by a British colleague, the result of a (rather esoteric) line of thinking on his part, having to do, not with Shakespeare, but with Cockney rhyming slang. I confess I didn’t find the name particularly flattering—I mean, “Chevelle” is far cooler! Yet, despite my protests, it was not long before I caught myself raising my head automatically upon mention of the word “bubble,” no matter the context!
So you can imagine the headaches I’ve developed recently, as the housing bubble is bursting here in America with a deafening “Bang!” Policy makers have been scrambling their heads, trying to devise ways to deal with the fact that some bubbles are less... “fun” that others!
The crux of the debate was eloquently put by Fed Governor Frederic Mishkin last week. Here is my paraphrased version:
Are some bubbles more dangerous than others? What should we do about them? Sit and watch, or take action? And, when it comes to action, what should that involve? Interest rates or regulation?
From bubble baths to NASDAQ: Some basic truths first: Bubbles can be quite inebriating—be it bubble gums, bubble baths, champagne bubbles or sky-rocketing stock prices at NASDAQ. As such, they also tend to be extremely inviting: Nobody wants to feel left out, so everyone floods in, the party gets crowded, and stock prices rise exponentially, reaching levels that cannot be justified by “fundamentals” (like corporate profitability, economic growth, etc). Meanwhile, if you are one of these “sober” voices calling for caution, the most likely response you’re going to get is "Have another glass!"
One day, Bang!! What next?
Well, it depends on the bubble. Bubble gums are pretty safe. Ditto for champagne bubbles: No matter how wasted you get, somehow, someway you’ll make it home. Stock market bubbles are a touch messier: The BANG will be usually accompanied by an impressive destruction of wealth, as the prices of your (and many others’) stocks decline calamitously.
Still, not that disastrous: You may have lost money, a LOT of money, but you still have your home, your car, your wife and kids. Your job too… if you’re lucky. And in the process, you may have even learnt a lesson: Next time, you’ll look for more “sensible” companies to put your savings at work, rather than investing in baloney start-ups with as inventive business ideas as online recycling of pet poo.
So these are the kind of bubbles it’s ok to sit and watch. But could there be bubbles that are more catastrophic?
Feedback loops: That’s what the Fed seems to think. Accordingly, bubbles that are fuelled by more and more borrowing can be particularly dangerous: Once they burst, they cause severe damage, not only to the “drunk ones” but to the financial system as a whole. Which in turn means that you and me, the “sober” ones who stayed away from the party, will also pay a big price in the form of slower economic growth, job losses, expensive access to credit, etc etc.
The recent housing bubble is a case in point. You had more and more people buying homes, as low interest rates and financial innovation (like the originate-to-distribute model) spurred growth in the issuance of mortgages. Home prices went up. Banks became complacent and loosened their credit standards: With rising home prices, they could always foreclose the property and get their money back if a borrower defaulted. So more mortgages were extended. Prices went even higher… more borrowing ensued… A vicious “feedback loop” that (next time!) should be stopped. But how?
Not me! That’s certainly what former Fed Chairman Alan Greenspan would have said. Ben seems to share that view: It’s not up to monetary policy (interest rates, basically) to correct the situation. And this for a number of reasons:
TiVo vs. TiVo Inc.: First, the objective of monetary policy is to promote a healthy pace of economic growth while maintaining price stability. When it comes to “price stability,” what the Fed cares about is consumer prices (e.g. the prices of cars or TiVos) not asset prices (e.g. the prices of homes or tech stocks).
Here is why: Asset prices send a signal to investors about the profitability of putting money into a particular business venture. They are therefore critical in channeling capital to (what are perceived as) productive economic sectors (be it technology companies or real estate). Any government interference in the form of, say, setting price “ceilings” on specific assets would distort the resource allocation process, compromising economic progress and efficiency.
Why me?! A second reason is that a bubble may be occurring in a particular class of assets—say housing—rather than in every asset. Therefore, by raising interest rates to stop that bubble from inflating further, the Fed will be hurting at the same time the entire economy. And why should I, the tomato paste producer, be paying higher interest rates because you, the online poo-recycler, are putting more and more money to more garbage “tech” ventures?
Is that a bubble? But there’s another problem: It’s actually not that easy to call a bubble a “bubble.” A bubble occurs when the price of an asset rises enough to deviate from a “fair” price that is based on “fundamentals.” And, as many will attest, it’s not easy to determine that “fair price.” Besides, if the Fed could know that price, why can’t investors? They’re both as smart and have access to the same information, right?
Regulate: With monetary policy “out,” the Fed seems inclined to pitch for regulation as the instrument for dealing with bubbles—the dangerous ones, that is. The objective would be to avoid those feedback loops between credit growth and asset price bubbles: For example, by re-linking the incentives for issuing mortgages to the quality of the loans rather than the volume; by re-establishing proper checks and balances on borrowers and their ability to pay; by improving the performance of credit rating agencies.
Some also are talking about the Fed assuming new powers that would allow it to influence the behavior of financial institutions if this is deemed to lead to systemic risks. Others have proposed making banks’ capital requirements “anti-cyclical”: That is, during good times, banks would be required to increase the “cushions” of capital they are required to hold, making it more expensive for them to lend more, and thus curbing their overall lending.
As you can see, ideas abound, and not all are flawless. But the environment is ripe, the frustration real and the chatter louder, so expect to see regulatory action sooner rather than later.
The three witches in Macbeth, by William Shakespeare.
At my first job, more than a decade ago, I was given the nickname “bubble.” The term was coined by a British colleague, the result of a (rather esoteric) line of thinking on his part, having to do, not with Shakespeare, but with Cockney rhyming slang. I confess I didn’t find the name particularly flattering—I mean, “Chevelle” is far cooler! Yet, despite my protests, it was not long before I caught myself raising my head automatically upon mention of the word “bubble,” no matter the context!
So you can imagine the headaches I’ve developed recently, as the housing bubble is bursting here in America with a deafening “Bang!” Policy makers have been scrambling their heads, trying to devise ways to deal with the fact that some bubbles are less... “fun” that others!
The crux of the debate was eloquently put by Fed Governor Frederic Mishkin last week. Here is my paraphrased version:
Are some bubbles more dangerous than others? What should we do about them? Sit and watch, or take action? And, when it comes to action, what should that involve? Interest rates or regulation?
From bubble baths to NASDAQ: Some basic truths first: Bubbles can be quite inebriating—be it bubble gums, bubble baths, champagne bubbles or sky-rocketing stock prices at NASDAQ. As such, they also tend to be extremely inviting: Nobody wants to feel left out, so everyone floods in, the party gets crowded, and stock prices rise exponentially, reaching levels that cannot be justified by “fundamentals” (like corporate profitability, economic growth, etc). Meanwhile, if you are one of these “sober” voices calling for caution, the most likely response you’re going to get is "Have another glass!"
One day, Bang!! What next?
Well, it depends on the bubble. Bubble gums are pretty safe. Ditto for champagne bubbles: No matter how wasted you get, somehow, someway you’ll make it home. Stock market bubbles are a touch messier: The BANG will be usually accompanied by an impressive destruction of wealth, as the prices of your (and many others’) stocks decline calamitously.
Still, not that disastrous: You may have lost money, a LOT of money, but you still have your home, your car, your wife and kids. Your job too… if you’re lucky. And in the process, you may have even learnt a lesson: Next time, you’ll look for more “sensible” companies to put your savings at work, rather than investing in baloney start-ups with as inventive business ideas as online recycling of pet poo.
So these are the kind of bubbles it’s ok to sit and watch. But could there be bubbles that are more catastrophic?
Feedback loops: That’s what the Fed seems to think. Accordingly, bubbles that are fuelled by more and more borrowing can be particularly dangerous: Once they burst, they cause severe damage, not only to the “drunk ones” but to the financial system as a whole. Which in turn means that you and me, the “sober” ones who stayed away from the party, will also pay a big price in the form of slower economic growth, job losses, expensive access to credit, etc etc.
The recent housing bubble is a case in point. You had more and more people buying homes, as low interest rates and financial innovation (like the originate-to-distribute model) spurred growth in the issuance of mortgages. Home prices went up. Banks became complacent and loosened their credit standards: With rising home prices, they could always foreclose the property and get their money back if a borrower defaulted. So more mortgages were extended. Prices went even higher… more borrowing ensued… A vicious “feedback loop” that (next time!) should be stopped. But how?
Not me! That’s certainly what former Fed Chairman Alan Greenspan would have said. Ben seems to share that view: It’s not up to monetary policy (interest rates, basically) to correct the situation. And this for a number of reasons:
TiVo vs. TiVo Inc.: First, the objective of monetary policy is to promote a healthy pace of economic growth while maintaining price stability. When it comes to “price stability,” what the Fed cares about is consumer prices (e.g. the prices of cars or TiVos) not asset prices (e.g. the prices of homes or tech stocks).
Here is why: Asset prices send a signal to investors about the profitability of putting money into a particular business venture. They are therefore critical in channeling capital to (what are perceived as) productive economic sectors (be it technology companies or real estate). Any government interference in the form of, say, setting price “ceilings” on specific assets would distort the resource allocation process, compromising economic progress and efficiency.
Why me?! A second reason is that a bubble may be occurring in a particular class of assets—say housing—rather than in every asset. Therefore, by raising interest rates to stop that bubble from inflating further, the Fed will be hurting at the same time the entire economy. And why should I, the tomato paste producer, be paying higher interest rates because you, the online poo-recycler, are putting more and more money to more garbage “tech” ventures?
Is that a bubble? But there’s another problem: It’s actually not that easy to call a bubble a “bubble.” A bubble occurs when the price of an asset rises enough to deviate from a “fair” price that is based on “fundamentals.” And, as many will attest, it’s not easy to determine that “fair price.” Besides, if the Fed could know that price, why can’t investors? They’re both as smart and have access to the same information, right?
Regulate: With monetary policy “out,” the Fed seems inclined to pitch for regulation as the instrument for dealing with bubbles—the dangerous ones, that is. The objective would be to avoid those feedback loops between credit growth and asset price bubbles: For example, by re-linking the incentives for issuing mortgages to the quality of the loans rather than the volume; by re-establishing proper checks and balances on borrowers and their ability to pay; by improving the performance of credit rating agencies.
Some also are talking about the Fed assuming new powers that would allow it to influence the behavior of financial institutions if this is deemed to lead to systemic risks. Others have proposed making banks’ capital requirements “anti-cyclical”: That is, during good times, banks would be required to increase the “cushions” of capital they are required to hold, making it more expensive for them to lend more, and thus curbing their overall lending.
As you can see, ideas abound, and not all are flawless. But the environment is ripe, the frustration real and the chatter louder, so expect to see regulatory action sooner rather than later.
Meanwhile, we can all continue our detoxicating period with another glass of… water. Bubbly, of course!
Glossary: asset prices, consumer prices, bubbles, fundamentals, capital requirements, cockney slang, Macbeth.
Glossary: asset prices, consumer prices, bubbles, fundamentals, capital requirements, cockney slang, Macbeth.
Sunday, May 11, 2008
FX Swaps Misbehaving
You’re in the middle of planning a summer tour of “classical” Greece for your family: The Parthenon in Athens, the spectacular oracle in Delphi, the ancient theater of Epidauros, a few beaches in between. But you need around 15,000 euros. What do you do? Well, a number of things:
Spots and forwards:
(a) You can go to your bank and get a one-year loan of 15,000 euros at, say, 4.00% interest. After one year you’ll have to pay back €15,600—principal and interest.
(b) You can go to your bank, borrow 23,250 dollars for a year at, say, 2.00% interest and then exchange them for euros at your local foreign exchange office. At around 1.55 dollars for each euro (the current “spot” rate), you get the €15,000 that you need. After one year, you will have to return $23,715 to your bank.
In both cases the “story” is the same: A curious American with good credit record and a liking for “history with some beaches in between,” borrowing 15,000 euros. Therefore, provided that there are no rules stopping you from borrowing in euros; and the transaction fees are the same; both options should cost exactly the same.
It's easy to see that (a) and (b) will cost the same if you and your bank agree today to change dollars for euros at a rate of $/€1.52 in a year's time: Under the first option, you pay back €15,600. In the second, you pay $23,715. The 1.52 is the ratio of the two amounts. This agreement with your bank is a one-year forward agreement; and the exchange rate that you pre-determine (here 1.52) is the forward rate.
Parthenon or Disneyland? Turns out, you have one more option: You go to your bank and borrow $23,250 at 2.00% interest. You then go online and place an ad: “Does anyone out there want to swap dollars for euros?”
Soon enough, a Greek appears: Very business-minded, he wants to lend the dollars to his neighbor, who is planning a summer vacation with his family to the American equivalent of the Parthenon: Disneyland!
So the two of you enter an agreement—a foreign exchange swap agreement: The Greek gives you 15,000 euros for a year, in exchange for your $23,250—fair, since the spot exchange rate is 1.55. At the end of the year he will give you $23,250 back in exchange for euros. But how many euros should you pay him back? Put it differently, at what exchange rate will you swap the dollars back to euros?
Once again the “story” is fundamentally the same—you borrowing 15,000 euros. So if the costs of the transaction are the same and IF, of course, you can trust the Greeks, you should be indifferent about which option to choose. This means you should be paying the same rate as in (b)—the forward rate of 1.52—which translates to around 15,300 euros for the Greek.
Swaps misbehaving: However convoluted this swapping sounds, this is exactly what many banks do when they want to raise funds in foreign currency: They borrow in their local currency and then swap it in the FX swap market. And when it comes to the dollar and the euro, the most widespread currencies in the world, this market extremely deep and liquid…
...Till last August! Suddenly, FX swaps seemed far more expensive than "option (a)"--that is, borrowing dollars directly from other banks at the so-called LIBOR rate (the interest rates at which banks lend to each other). But why did that happen? Why didn’t Europeans switch to the (apparently) cheaper Libor market? Haven't they heard of arbitrage? Are they not that smart?!
A number of explanations have been on offer.
Can't trust the Greeks? One possibility is "discriminatory" mistrust against Europeans—say if they were suddenly perceived as exceptionally risky. This could have raised the price of FX swaps, on which Europeans relied most, above the Libor, which applies to a wider pool of banks. Possible, though not entirely compelling: Thinking of the names that were floating around as potential “time-bombs” (Lehman, Citigroup or the now legendary Bear Stearns), I’d say American banks were at least as deep in trouble.
Premium for collateral? Another has to do with a subtle difference between the Libor and FX swap markets. Remember your swap with the Greek? Suppose he disappeared and never paid you back. Bad, though not terrible! You simply don’t pay him back either. That is, in a FX swap agreement you can use your obligation to repay as “collateral,” or insurance against the risk that your counterparty fails you. This is not the case when you borrow outright from your bank, without collateral. So in an environment of mutual mistrust, Europeans might have had trouble borrowing in the (uncollateralized) Libor market, turning therefore to the FX swap market to get dollars. And as they flood in, the market gets crowded and… more and more expensive.
Blame it on the Libor? Another explanation has to do with the Libor itself. The Libor is an average rate of interest that banks lend to each other, calculated based on quotes from a panel of 16 banks. These 16 banks are selected on the basis of their “reputation, scale of market activity and perceived expertise in the currency concerned.” It is therefore conceivable that, if the need for dollars were disproportionately larger for banks that are not in the panel (e.g. small, regional or less creditworthy banks which should typically pay rates above Libor), the FX swap market would have reflected the (more expensive) funding costs of these banks.
Cheating? As always, there is cheating. With everyone wary of which bank will be the next to fall, there were rumors that some of the banks in the Libor panel were quoting rates that were lower than their true borrowing costs. Why would they do that?? Because a high rate might raise suspicions they had trouble raising money, prompting a stampede against them.
Where does this leave us? While the explanations are not 100 percent conclusive, we know at least one thing: FX swaps have been darn expensive! And this can throw light to a couple of questions that have kept me from sleeping for a few weeks:
Why is the US Fed providing the European Central Bank (ECB) with dollars? And why on earth does the ECB have to be the dollar provider for European banks? Isn’t the foreign exchange market for the euro and the dollar the deepest and most liquid in the world? Yes, normally… but for now, FX swaps are misbehaving!
Are European banks more in trouble that their American brethren? Not necessarily. At the Fed’s recent auction to lend dollars to (primarily) American banks (the so-called Term Auction Facility), demand for dollars was record high, at around 97 billion. So the ability to raise money is similarly dire on both sides of the Atlantic.
Finally, can you trust the Greeks? Most of the times... And when you go to Delphi, don’t forget to ask the oracle when this will all end!
Glossary: spot, forward, foreign exchange swap, LIBOR, the Parthenon, Disneyland.
Further readings:
Planning the first swap
The latest swap
And for the brave ones…Read this!
Spots and forwards:
(a) You can go to your bank and get a one-year loan of 15,000 euros at, say, 4.00% interest. After one year you’ll have to pay back €15,600—principal and interest.
(b) You can go to your bank, borrow 23,250 dollars for a year at, say, 2.00% interest and then exchange them for euros at your local foreign exchange office. At around 1.55 dollars for each euro (the current “spot” rate), you get the €15,000 that you need. After one year, you will have to return $23,715 to your bank.
In both cases the “story” is the same: A curious American with good credit record and a liking for “history with some beaches in between,” borrowing 15,000 euros. Therefore, provided that there are no rules stopping you from borrowing in euros; and the transaction fees are the same; both options should cost exactly the same.
It's easy to see that (a) and (b) will cost the same if you and your bank agree today to change dollars for euros at a rate of $/€1.52 in a year's time: Under the first option, you pay back €15,600. In the second, you pay $23,715. The 1.52 is the ratio of the two amounts. This agreement with your bank is a one-year forward agreement; and the exchange rate that you pre-determine (here 1.52) is the forward rate.
Parthenon or Disneyland? Turns out, you have one more option: You go to your bank and borrow $23,250 at 2.00% interest. You then go online and place an ad: “Does anyone out there want to swap dollars for euros?”
Soon enough, a Greek appears: Very business-minded, he wants to lend the dollars to his neighbor, who is planning a summer vacation with his family to the American equivalent of the Parthenon: Disneyland!
So the two of you enter an agreement—a foreign exchange swap agreement: The Greek gives you 15,000 euros for a year, in exchange for your $23,250—fair, since the spot exchange rate is 1.55. At the end of the year he will give you $23,250 back in exchange for euros. But how many euros should you pay him back? Put it differently, at what exchange rate will you swap the dollars back to euros?
Once again the “story” is fundamentally the same—you borrowing 15,000 euros. So if the costs of the transaction are the same and IF, of course, you can trust the Greeks, you should be indifferent about which option to choose. This means you should be paying the same rate as in (b)—the forward rate of 1.52—which translates to around 15,300 euros for the Greek.
Swaps misbehaving: However convoluted this swapping sounds, this is exactly what many banks do when they want to raise funds in foreign currency: They borrow in their local currency and then swap it in the FX swap market. And when it comes to the dollar and the euro, the most widespread currencies in the world, this market extremely deep and liquid…
...Till last August! Suddenly, FX swaps seemed far more expensive than "option (a)"--that is, borrowing dollars directly from other banks at the so-called LIBOR rate (the interest rates at which banks lend to each other). But why did that happen? Why didn’t Europeans switch to the (apparently) cheaper Libor market? Haven't they heard of arbitrage? Are they not that smart?!
A number of explanations have been on offer.
Can't trust the Greeks? One possibility is "discriminatory" mistrust against Europeans—say if they were suddenly perceived as exceptionally risky. This could have raised the price of FX swaps, on which Europeans relied most, above the Libor, which applies to a wider pool of banks. Possible, though not entirely compelling: Thinking of the names that were floating around as potential “time-bombs” (Lehman, Citigroup or the now legendary Bear Stearns), I’d say American banks were at least as deep in trouble.
Premium for collateral? Another has to do with a subtle difference between the Libor and FX swap markets. Remember your swap with the Greek? Suppose he disappeared and never paid you back. Bad, though not terrible! You simply don’t pay him back either. That is, in a FX swap agreement you can use your obligation to repay as “collateral,” or insurance against the risk that your counterparty fails you. This is not the case when you borrow outright from your bank, without collateral. So in an environment of mutual mistrust, Europeans might have had trouble borrowing in the (uncollateralized) Libor market, turning therefore to the FX swap market to get dollars. And as they flood in, the market gets crowded and… more and more expensive.
Blame it on the Libor? Another explanation has to do with the Libor itself. The Libor is an average rate of interest that banks lend to each other, calculated based on quotes from a panel of 16 banks. These 16 banks are selected on the basis of their “reputation, scale of market activity and perceived expertise in the currency concerned.” It is therefore conceivable that, if the need for dollars were disproportionately larger for banks that are not in the panel (e.g. small, regional or less creditworthy banks which should typically pay rates above Libor), the FX swap market would have reflected the (more expensive) funding costs of these banks.
Cheating? As always, there is cheating. With everyone wary of which bank will be the next to fall, there were rumors that some of the banks in the Libor panel were quoting rates that were lower than their true borrowing costs. Why would they do that?? Because a high rate might raise suspicions they had trouble raising money, prompting a stampede against them.
Where does this leave us? While the explanations are not 100 percent conclusive, we know at least one thing: FX swaps have been darn expensive! And this can throw light to a couple of questions that have kept me from sleeping for a few weeks:
Why is the US Fed providing the European Central Bank (ECB) with dollars? And why on earth does the ECB have to be the dollar provider for European banks? Isn’t the foreign exchange market for the euro and the dollar the deepest and most liquid in the world? Yes, normally… but for now, FX swaps are misbehaving!
Are European banks more in trouble that their American brethren? Not necessarily. At the Fed’s recent auction to lend dollars to (primarily) American banks (the so-called Term Auction Facility), demand for dollars was record high, at around 97 billion. So the ability to raise money is similarly dire on both sides of the Atlantic.
Finally, can you trust the Greeks? Most of the times... And when you go to Delphi, don’t forget to ask the oracle when this will all end!
Glossary: spot, forward, foreign exchange swap, LIBOR, the Parthenon, Disneyland.
Further readings:
Planning the first swap
The latest swap
And for the brave ones…Read this!
Saturday, May 3, 2008
Let them swim in rice pudding!
The first serious piece of art I ever bought was a photograph of naked, weightless, visually confounding body parts. Human body parts! To be specific, it was female human bodies, of all sizes and shapes, swimming naked in a pool of… rice starch—the visual result of which is a collection of disconnected body fragments floating in a whitish ethereal medium and conveying a sense of “zero gravity” (the name of the series).
The artist, a soul-searched Austrian with the inevitable sense of irony that Europeans seem to be born with, spent days cooking the rice starch, in order to fill up a two-thousand-gallon tank he set up for the photo-shoot at the rooftop of his New York loft.
That was early 2003. Turns out my piece was a tremendous investment, considering how much it has appreciated in value since then. And this for more than one reasons: First my artistic acumen, as the Austrian is gradually rising to international acclaim; secondly, the phenomenal increase in art prices in recent years, as floods of “new” money rushed to anything that bore the banner “store of value,” from stocks and bonds, to real estate to gold to, yes, art.
But when it comes to my photo, one more crucial factor is at play: The price of rice! Rice prices have more than quadrupled since 2003, for reasons ranging from declining productivity, skyrocketing costs of fuel and fertilizers, the battle for acreage as more land is dedicated to ethanol production, drought here and there or the simple fact that the world’s erstwhile poor are discovering the benefits of three meals a day. The outcome? A nice $4,000 windfall to the value of my photo, strictly on a “production cost” basis!
Yet, what is a boon for me, is a hefty blow for billions (repeat, billions) around the globe. Rice is a staple food for more than half the world’s population. It’s no accident that the Japanese describe “luck” as “having a rice dumpling flying into your mouth!” And it’s no wonder that faced with shortages, inflation and social unrest, governments are getting anxious. And many are reacting! What are they doing?
Bashing free trade: Not that it was ever out of fashion, but free-trade bashing is back in force. Indeed, some "quarters" are blaming trade liberalization, and the concomitant reliance on imports to meet local food needs, as a reason for today's woos. Hmmm.. Let's see why.
You may have heard that import tariffs are bad. Here is why. Import tariffs make goods at home more expensive than the same goods sold abroad. For example, a low-cost Thai rice producer may be willing to sell me one ton of high-quality rice for around 1,100 dollars. But if my government imposes, say, a 30% tariff on imported rice, the total price I pay is $1,430—$1,100 to the Thai exporter and $330 to the government. Evidently, I’ll pass this higher price on to consumers—penalizing all of you, from the simple, rice-and-veggies types to those who love swimming in rice pudding!
But tariffs are bad for another very important reason: They impede the efficient allocation of resources such as land, labor and capital. By (artificially) raising the price of, say, rice, they create incentives for entrepreneurs to shift their resources to rice production. Why use my land to breed cattle or build a semi-conductor factory when selling rice is now at least as profitable a business? Why go through the painstaking (and expensive) process of college education, if I can earn a decent living operating a rice miller? Tariffs therefore help “cosset” a small number of producers at the expense of the consuming majority and, importantly, of productive efficiency and scientific progress.
Countries that saw the advantages of free(er) trade moved to lower their tariffs (at least selectively), and have enjoyed lower prices and a more efficient resource allocation ever since… Up till now. As commendable as it is, free trade works provided countries are willing to trade: If I cut my tariffs on rice, give up on rice production and shift my resources to electronics, I implicitly trust that you, the efficient rice producer, will always sell me your rice. But what if you suddenly decided to cheat?
The cheaters: While you might not think of yourself as a natural cheater, think again when, as a government, you’re faced with skyrocketing world rice prices and food riots on the streets. Allocative efficiency no longer looks like the right priority. The burning issue is self-sufficiency.
And so you "cheat," like a slew of countries have done recently, including India and Vietnam, two of the largest rice exporters in the world. In violation of their “gentlemen’s agreement” under free trade, these countries have restricted their exports in an effort to shield their domestic rice prices from world developments. How does this work?
Export taxes have the opposite objective from import tariffs. Whereas the latter aim at increasing the domestic price relative to the world price (to protect domestic producers), export taxes are imposed to keep the domestic price below the world price.
The “mechanics” is simple: Let’s say I am a rice producer in Thailand and the price I can fetch for a ton of rice in world markets is $1,100. But if the Thai government puts a $550/ton tax on my exports, the price I receive in the end is just $550—the rest goes to the government. In this case, I am indifferent between selling my rice to Americans for $1,100 or to my fellow Thais for $550. The domestic price is thus kept (artificially) low. This sounds good for Thai consumers but it discourages rice production and resources are, once again, diverted to less efficient business activities.
So are the "cheated" right to compain? Take a look at the Philippines: The world’s second largest rice importer and a rice-loving nation, the country has recently had trouble meeting its target for rice imports, managing to cover only half of its needs. I'd certainly complain myself in this case, though slamming free trade (as opposed to the violation of free trade rules) might be somewhat misplaced.
The artist, a soul-searched Austrian with the inevitable sense of irony that Europeans seem to be born with, spent days cooking the rice starch, in order to fill up a two-thousand-gallon tank he set up for the photo-shoot at the rooftop of his New York loft.
That was early 2003. Turns out my piece was a tremendous investment, considering how much it has appreciated in value since then. And this for more than one reasons: First my artistic acumen, as the Austrian is gradually rising to international acclaim; secondly, the phenomenal increase in art prices in recent years, as floods of “new” money rushed to anything that bore the banner “store of value,” from stocks and bonds, to real estate to gold to, yes, art.
But when it comes to my photo, one more crucial factor is at play: The price of rice! Rice prices have more than quadrupled since 2003, for reasons ranging from declining productivity, skyrocketing costs of fuel and fertilizers, the battle for acreage as more land is dedicated to ethanol production, drought here and there or the simple fact that the world’s erstwhile poor are discovering the benefits of three meals a day. The outcome? A nice $4,000 windfall to the value of my photo, strictly on a “production cost” basis!
Yet, what is a boon for me, is a hefty blow for billions (repeat, billions) around the globe. Rice is a staple food for more than half the world’s population. It’s no accident that the Japanese describe “luck” as “having a rice dumpling flying into your mouth!” And it’s no wonder that faced with shortages, inflation and social unrest, governments are getting anxious. And many are reacting! What are they doing?
Bashing free trade: Not that it was ever out of fashion, but free-trade bashing is back in force. Indeed, some "quarters" are blaming trade liberalization, and the concomitant reliance on imports to meet local food needs, as a reason for today's woos. Hmmm.. Let's see why.
You may have heard that import tariffs are bad. Here is why. Import tariffs make goods at home more expensive than the same goods sold abroad. For example, a low-cost Thai rice producer may be willing to sell me one ton of high-quality rice for around 1,100 dollars. But if my government imposes, say, a 30% tariff on imported rice, the total price I pay is $1,430—$1,100 to the Thai exporter and $330 to the government. Evidently, I’ll pass this higher price on to consumers—penalizing all of you, from the simple, rice-and-veggies types to those who love swimming in rice pudding!
But tariffs are bad for another very important reason: They impede the efficient allocation of resources such as land, labor and capital. By (artificially) raising the price of, say, rice, they create incentives for entrepreneurs to shift their resources to rice production. Why use my land to breed cattle or build a semi-conductor factory when selling rice is now at least as profitable a business? Why go through the painstaking (and expensive) process of college education, if I can earn a decent living operating a rice miller? Tariffs therefore help “cosset” a small number of producers at the expense of the consuming majority and, importantly, of productive efficiency and scientific progress.
Countries that saw the advantages of free(er) trade moved to lower their tariffs (at least selectively), and have enjoyed lower prices and a more efficient resource allocation ever since… Up till now. As commendable as it is, free trade works provided countries are willing to trade: If I cut my tariffs on rice, give up on rice production and shift my resources to electronics, I implicitly trust that you, the efficient rice producer, will always sell me your rice. But what if you suddenly decided to cheat?
The cheaters: While you might not think of yourself as a natural cheater, think again when, as a government, you’re faced with skyrocketing world rice prices and food riots on the streets. Allocative efficiency no longer looks like the right priority. The burning issue is self-sufficiency.
And so you "cheat," like a slew of countries have done recently, including India and Vietnam, two of the largest rice exporters in the world. In violation of their “gentlemen’s agreement” under free trade, these countries have restricted their exports in an effort to shield their domestic rice prices from world developments. How does this work?
Export taxes have the opposite objective from import tariffs. Whereas the latter aim at increasing the domestic price relative to the world price (to protect domestic producers), export taxes are imposed to keep the domestic price below the world price.
The “mechanics” is simple: Let’s say I am a rice producer in Thailand and the price I can fetch for a ton of rice in world markets is $1,100. But if the Thai government puts a $550/ton tax on my exports, the price I receive in the end is just $550—the rest goes to the government. In this case, I am indifferent between selling my rice to Americans for $1,100 or to my fellow Thais for $550. The domestic price is thus kept (artificially) low. This sounds good for Thai consumers but it discourages rice production and resources are, once again, diverted to less efficient business activities.
So are the "cheated" right to compain? Take a look at the Philippines: The world’s second largest rice importer and a rice-loving nation, the country has recently had trouble meeting its target for rice imports, managing to cover only half of its needs. I'd certainly complain myself in this case, though slamming free trade (as opposed to the violation of free trade rules) might be somewhat misplaced.
Indeed, export taxes contribute to the problem: In principle, soaring world prices should encourage higher production, helping meet part of the additional demand. But with export taxes keeping prices low, local rice farmers no longer have the incentive to raise their production. Worse, the cheaters have now created a precedent that others might follow. Thailand for example, the world’s largest rice exporter, has so far refrained from imposing export taxes, allowing its exporters to expand their production and benefit from the boom. But if I am a Thai exporter, I may be suspicious about what the government might do next. And this uncertainty may prevent me from taking the risk of investing in facilities to raise production. Production is thus kept low, prices high, most of us lose.
So what next? Rice cartels? Unlikely to work—too many producers, too hard to get them to coordinate, too tiny the rice exports as a share of global production (only 6-7% of global rice production is exported), too difficult to adjust rice supply up or down fast enough in response to world price developments (problems ranging from weather, availability of acreage and lack of storage facilities, to name a few).
A return to autarky? Not really, though with food security the word du jour, governments are spending billions of taxpayer money to promote domestic agriculture and, as Malaysia put it, convert entire regions into “rice bowls.” Unclear where this can end and what will imply for debt accumulation, as rice is only one of the staples facing climbing prices, not to mention fuel and energy. The sustainable solution lies in encouraging private investment to be directed to agricultural research and production, which in turn requires the removal of uncertainty over the investor's horizon--and export taxes can't help!
In the meantime, one thing is certain… it might be some time before the Austrian can have an encore of his rice-pudding party in his loft!
Glossary: import tariffs, export taxes, free trade, autarky, cartels, rice pudding.
So what next? Rice cartels? Unlikely to work—too many producers, too hard to get them to coordinate, too tiny the rice exports as a share of global production (only 6-7% of global rice production is exported), too difficult to adjust rice supply up or down fast enough in response to world price developments (problems ranging from weather, availability of acreage and lack of storage facilities, to name a few).
A return to autarky? Not really, though with food security the word du jour, governments are spending billions of taxpayer money to promote domestic agriculture and, as Malaysia put it, convert entire regions into “rice bowls.” Unclear where this can end and what will imply for debt accumulation, as rice is only one of the staples facing climbing prices, not to mention fuel and energy. The sustainable solution lies in encouraging private investment to be directed to agricultural research and production, which in turn requires the removal of uncertainty over the investor's horizon--and export taxes can't help!
In the meantime, one thing is certain… it might be some time before the Austrian can have an encore of his rice-pudding party in his loft!
Glossary: import tariffs, export taxes, free trade, autarky, cartels, rice pudding.
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