How important is it to have an economics background to run the Federal Reserve? The FT’s US economics editor Sam Fleming talks to several leading economists on whether being versed in the theory is a basic requirement for a Fed chair.
Current US Fed Chair Janet Yellen could be heading into the final six months of her first term at Fed Chair. If Donald Trump does not give her a second term it may usher in new thinking from the US Government. There is no requirement for Donald Trump to appoint someone who is from the academic world of economics. They mention the success of Paul Volcker as Fed Chair who didn’t have a PhD in Economics but had a Masters Degree and also experience in banking (Chase) and commercial sector. From the left you have – Janet Yellen, Paul Volcker, Alan Greenspan and Ben Bernanke.
Below is a recent documentary from Deutsche Welle (DW – Germany’s international broadcaster) on the impact of exploding real estate prices, zero interest rate (see graph below) and a rising stock market. The higher income groups are benefiting greatly from these conditions but how does it effect middle income earners especially those in retirement. The DW documentary addresses these issues and explains how money deals have become detached from the real economy. Worth a look.
For years, the world’s central banks have been pursuing a policy of cheap money. The first and foremost is the ECB (European Central Bank), which buys bad stocks and bonds to save banks, tries to fuel economic growth and props up states that are in debt. But what relieves state budgets to the tune of hundreds of billions annoys savers: interest rates are close to zero.
The fiscal policies of the central banks are causing an uncontrolled global deluge of money. Experts are warning of new bubbles. In real estate, for example: it’s not just in German cities that prices are shooting up. In London, a one-bed apartment can easily cost more than a million Euro. More and more money is moving away from the real economy and into the speculative field. Highly complex financial bets are taking place in the global casino – gambling without checks and balances. The winners are set from the start: in Germany and around the world, the rich just get richer. Professor Max Otte says: “This flood of money has caused a dangerous redistribution.
Those who have, get more.” But with low interest rates, any money in savings accounts just melts away. Those with debts can be happy. But big companies that want to swallow up others are also happy: they can borrow cheap money for their acquisitions. Coupled with the liberalization of the financial markets, money deals have become detached from the real economy. But it’s not just the banks that need a constant source of new, cheap money today. So do states. They need it to keep a grip on their mountains of debt. It’s a kind of snowball system. What happens to our money? Is a new crisis looming? The film ‘The Money Deluge’ casts a new and surprising light on our money in these times of zero interest rates.
Teaching ethics to my Yr 10 class I have used the sub-prime crisis as an example. As with behavioural economics the conventional view of finance assumes that markets are efficient and that the price of shares, bonds and other financial instruments are a reflection of the fundamental economic values that they represent. Behavioural finance is all about understanding why and how financial markets are inefficient. If there is a difference between the market price of a share or bond and its fundamental value then in conventional economics no one can make money in financial markets by exploiting the difference.
Global Financial Crisis
In July 2007 a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis. Sub-prime mortgages were loans that were high risk and many mortgage holders unable to meet their repayments. The mortgages were pooled into what was know as a Collaterised Debt Obligation (CDO) which were sliced into tranches – safe – okay – risky. Investors tended to buy safe tranches as they were rated AAA by the rating agencies. However the rating agencies were very generous in their assessment of these investments as they were paid by the banks who created the CDOs. Banks also were able to take out insurance on the CDO even if they didn’t own them. This was called a Credit Default Swap (CDS).
The flow chart (above) and video (below) shows how Goldman Sachs sold a CDO called Timberwolf to investors and proceeded to bet against that investment by buying insurance from AIG so that when the CDO failed they got a pay out from them. As you maybe aware AIG sold a lot of CDS’s and ultimately had to be bailed out by the US government. However a significant portion of the bailout money went to the banks that had created the problem.
Below is another very good clip from the Big Short that explains how the mortgage market brought down the financial system. Good references to CDO’s in which celebrity chef Anthony Bourdain compares fish to finance?
Below is an image from National Australia Bank (NAB) with regards to the prospects for credit markets in 2017 looking at various scenarios – Bearish, Bullish and Base Case.
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 indiates 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.
On the 8th November last year India’s Prime Minister, Narendra Modi, announced that all 500 and 1000 rupee notes could no longer be used as a medium of exchange – this accounts for 86% of cash in circulation. These notes could be exchanged for new ones by the end of the 2016.
Why did they outlaw the use of 500 and 1000 rupee notes?
- The main motivation was to remove the country of shadow economy millionaires hoarding of illegal cash. It is estimated that the shadow economy accounts for 20% of India’s GDP.
- Demonetisation increases the use of electronic banking allowing better tracking by tax authorities.
- The printing of new denomination money would hopefully inflate away the value of illegal cash in the shadow economy.
- Encourage people to deposit cash in the bank where it would earn interest
- Greater tax revenue for the government by firms declaring their earnings. This additional money could be used for infrastructure projects as well as tax incentives for companies.
What have been the problems?
- The Reserve Bank of India hasn’t been able to print the new money fast enough to replace the $207bn in rupees. There has been almost no new cash in rural banks and therefore keeping millions of farmers deposits that total $46bn. With limited cash in rural areas prices have collapsed.
- Factories in some cities have closed as employers can’t pay their workers although some have resorted to giving supermarket coupons to keep workers on the job.
- A dentist in an affluent part of Delhi has found a 70% fall in business since the cash ban.
- Outside the major cities cash transactions are very common and not recognising 500 and 1000 rupee notes provides a significant monetary shock for those areas
- Not all the shadow economy can move to a more legal environment with demonetisation and this represents a potential loss of economic activity.
- A shortage of cash has led to small businesses having to shut down.
In the long-run the forced priming of bank accounts and the switch to electronic payments will mobilize more money for lending and taxes.
Venezuela also became a country mostly without cash on December 16, sparking scattered protests and looting around the country as people fumed at having their already limited purchasing power cut off almost entirely.
As the nation’s most widely used banknote went out of circulation, the higher-denomination bills that were supposed to replace the 100-bolivar note had not yet arrived at banks or ATMs. That forced people to rely on credit cards and bank transfers or to try to make purchases with bundles of hard-to-find smaller bills often worth less than a penny each. The government was forced to delay the withdrawal of the 100-bolivar banknote until January 2. The graphic shows the volume of bank notes that are required to make $10m – Venezuela needs 14 sizable trucks to carry the 100-bolivar banknotes.
Source: The Economist – December 3rd 2016
Another good video from Paul Solman of PBS ‘Making Sense of Financial News’.
In his new book, “The End of Alchemy,” Mervyn King still worries that the world banking system hasn’t reformed itself, eight years after its excesses led to collapse. He states that it’s easy with hindsight to look back and say that regulations turned out to be inadequate as mortgage lending was riskier than was thought. Furthermore, you are of the belief that the system works and it takes an event like the GFC to discover that it actually doesn’t.
Paul Solman asks the question that a large part of the problem that caused the GFC was the Bank of England and the US Fed were not able to keep up with the financial innovation that was going on in both of these countries. King refutes this by saying that there were two issues that were prevalent before the GFC:
- Low interest rates around the world led to rising asset prices and trading looked very profitable.
- Leverage of the banking system rose very sharply – Leverage, meaning the ratio of the bank’s own money to the money it borrows in the form deposits or short-term loans.
Central banks exist to be lenders of last resort. Problem: Too big to fail. And that’s what began happening in England, just like America, in the ’80s and ’90s. There needs to be something much more robust and much more simple to prevent the same problem from happening again. King makes two proposals:
- Banks insure themselves against catastrophe by making enough safe, secure loans so they have assets of real value to pledge to the Central Bank if they need a cash infusion in a hurry.
- Force the banks to keep enough cash on hand to cover loans gone bad as during the crisis banks didn’t have enough equity finance to absorb losses without defaulting on the loans which banks have taken out, whether from other bits of the financial sector or from you and I as depositors.
He finally states that the Brexit vote doesn’t make any significant difference to the risks facing the global banking system. There were and are significant risks in that system because of the potential fragility of our banks, and because of the state of the world economy.
I blogged on the ‘Double Irish’ in 2014 and that this tax arrangement would be ended fully within four years.
Yesterday the European Commission ruled that a tax deal between the Irish government and Apple amounted to illegal state aid with Apple being ordered to pay a record-breaking €13bn (NZ$20bn) in back taxes to Ireland. Apple, the world’s biggest company, was paying a tax rate of just 1% and in 2014 was paying 0.005% when he usual corporate rate in Ireland is 12.5%. This equates to €50.00 tax for every €1 million earned.
The commission said Ireland’s tax arrangements – Double Irish – with Apple between 1991 and 2015 had allowed the US company to attribute sales to a “head office” that only existed on paper and could not have generated such profits. See below:
Double Irish is a tax avoidance procedure that some multinational corporations use to lower their corporate tax liability. The strategy uses payments between related institutions in a corporate structure to shift income from a higher-tax country to a lower-tax country. The most popular countries being the Cayman Islands, Bermuda, Jersey and Guernsey as they have corporate tax rates of 0% – see list of Central Government Corporate Tax Rates.
Many US technology companies have taken advantage of a loop hole in Irish corporate law which allowed them to be registered in Ireland without being tax-resident there – see chart below to see how it all works. Google for instance keeps it intellectual property in an Irish company that is tax-resident in Bermuda, which has a zero tax rate of corporate tax. However from January 2015 new companies domiciled in Ireland will also have to be tax-residents there, making the Double Irish impossible.