The financial cycle and macroeconomics: What have we learnt?

The financial cycle and macroeconomics: What have we learnt? By Claudio Borio
BIS Working Papers No 395
December 2012
http://www.bis.org/publ/work395.htm

It is high time we rediscovered the role of the financial cycle in macroeconomics. In the environment that has prevailed for at least three decades now, it is not possible to understand business fluctuations and the corresponding analytical and policy challenges without understanding the financial cycle. This calls for a rethink of modelling strategies and for significant adjustments to macroeconomic policies. This essay highlights the stylised empirical features of the financial cycle, conjectures as to what it may take to model it satisfactorily, and considers its policy implications. In the discussion of policy, the essay pays special attention to the bust phase, which is less well explored and raises much more controversial issues.

JEL classification: E30, E44, E50, G10, G20, G28, H30, H50

Keywords: financial cycle, business cycle, medium term, financial crises, monetary economy, balance sheet recessions, balance sheet repair

Mobilizing Resources, Building Coalitions: Local Power in Indonesia

Mobilizing Resources, Building Coalitions: Local Power in Indonesia, by Ryan Tans
Honolulu: East-West Center, 2012
Policy Studies, No. 64
ISBN: 978-0-86638-220-5
http://www.eastwestcenter.org/publications/mobilizing-resources-building-coalitions-local-power-in-indonesia

What have been the local political consequences of Indonesia's decentralization and electoral reforms? Some recent scholarship has emphasized continuity with Suharto's New Order, arguing that under the new rules, old elites have used money and intimidation to capture elected office. Studies detail the widespread practice of "money politics," in which candidates exchange patronage for support from voters and parties. Yet significant variation characterizes Indonesia's local politics, which suggests the need for an approach that differentiates contrasting power arrangements.

This study of three districts in North Sumatra province compares local politicians according to their institutional resource bases and coalitional strategies. Even if all practice money politics, they form different coalition types that depend on diverse institutions for political resources. The three ideal types of coalitions are political mafias, party machines, and mobilizing coalitions. Political mafias have a resource base limited to local state institutions and businesses; party machines bridge local and supra-local institutions; and mobilizing coalitions incorporate social organizations and groups of voters. Due to contrasting resource bases, the coalitions have different strategic option "menus," and they may experiment with various political tactics.

The framework developed here plausibly applies in other Indonesian districts to the extent that similar resource bases--namely local state institutions, party networks, and strong social and business organizations--are available to elites in other places.

About the Author: Ryan Tans is a doctoral student in political science at Emory University. Previously, he received a Master of Arts in Southeast Asian Studies from the National University of Singapore.

Unmitigated disasters? New evidence on the macroeconomic cost of natural catastrophes

Unmitigated disasters? New evidence on the macroeconomic cost of natural catastrophes. By Goetz von Peter, Sebastian von Dahlen and Sweta C Saxena

BIS Working Papers No 394
December 2012

http://www.bis.org/publ/work394.htm

 

Abstract: This paper presents a large panel study on the macroeconomic consequences of natural catastrophes and analyzes the extent to which risk transfer to insurance markets facilitates economic recovery. Our main results are that major natural catastrophes have large and signi cant negative e ects on economic activity, both on impact and over the longer run. However, it is mainly the uninsured losses that drive the subsequent macroeconomic cost, whereas sufficiently insured events are inconsequential in terms of foregone output. This result helps to disentangle conicting ndings in the literature, and puts the focus on risk transfer mechanisms to help mitigate the macroeconomic costs of natural catastrophes.

JEL classification: G22, O11, O44, Q54.

Keywords: Natural catastrophes, disasters, economic growth, insurance, risk transfer, reinsurance, recovery, development

Excerpts:

By using a novel and unique dataset, this paper measures the dynamic response of growth to major natural catastrophes, and examines the extent to which risk transfer to insurance markets facilitates economic recovery for a large cross-section of countries. With this aim, the paper makes three contributions to the literature. First, our analysis has a broader scope than other studies.  We construct a large panel with 8,252 country-year observations, covering 203 countries and jurisdictions between 1960 and 2011, matched with 2476 major natural catastrophes of four different physical types. Importantly, we make use of the most detailed statistics available on total and insured losses, obtained from industry sources. These unique data are better suited for the analysis than the public CRED database used in the existing literature.1 On the methodological side, we estimate the full time profile of economic growth in response to natural disasters in a dynamic specification. This allows us to present a more complete picture of growth dynamics than studies that focus on a particular time segment only.

Third, and most importantly, this is the first paper to make the link between natural catastrophes and economic growth conditional on risk transfer. This nuances the transmission channels, thereby helping to resolve the conflicting findings on catastrophe-related growth e ects in the literature.  In particular, we show that the uninsured part of disaster-related losses drives the subsequent macroeconomic cost in terms of foregone output. In focusing on economic activity, we recognize that disasters invariably diminish the wellbeing of affected populations even if growth rebounds.2 That said, there is little evidence that countries rebound from natural catastrophes when uninsured.  We nd that a typical (median) catastrophe causes a drop in growth of 0.6-1.0% on impact and results in a cumulative output loss of two to three times this magnitude, with higher estimates for larger (mean) catastrophes. Well insured catastrophes, by contrast, can be inconsequential or positive for growth over the medium term as insurance payouts help fund reconstruction efforts.

These fidings suggest that risk transfer to insurance markets has a macroeconomic value. This value may be particularly high for smaller nations that lack the capacity to (re)insure themselves against major natural disasters. The analysis thus contributes to the policy debate on different forms of post-disaster spending, as well as the balance between prevention ex ante and compensation ex post. Our finding that catastrophes have permanent output effects is also relevant for a growing literature that explains asset pricing puzzles through rare disasters. The extent to which risk transfer mitigates the macroeconomic cost of disasters is pertinent to the literature on finance and growth, which focuses on banks and stock markets but not on insurance. Considering the macroeconomic value of risk transfer could also enrich the macroprudential approach to the regulation and supervision of insurance companies.

The Need for "Un-consolidating" Consolidated Banks' Stress Tests

The Need for "Un-consolidating" Consolidated Banks' Stress Tests. By Eugenio Cerutti and Christian Schmieder
IMF, December 06, 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=40151.0

Summary: The recent crisis has spurred the use of stress tests as a (crisis) management and early warning tool. However, a weakness is that they omit potential risks embedded in the banking groups’ geographical structures by assuming that capital and liquidity are available wherever they are needed within the group. This assumption neglects the fact that regulations differ across countries (e.g., minimum capital requirements), and, more importantly, that home/host regulators might limit flows of capital or liquidity within a group during periods of stress. This study presents a framework on how to integrate this risk element into stress tests, and provides illustrative calculations on the size of the potential adjustments needed in the presence of some limits on intragroup flows for banks included in the June 2011 EBA stress tests.

Remarks of Under Secretary for Domestic Finance Mary Miller at the Office of Financial Research (OFR) and Financial Stability Oversight Council (FSOC) Conference on “Assessing Financial Intermediation: Measurement and Analysis”

Remarks of Under Secretary for Domestic Finance Mary Miller at the Office of Financial Research (OFR) and Financial Stability Oversight Council (FSOC) Conference on "Assessing Financial Intermediation: Measurement and Analysis"
Dec 6, 2012
http://www.treasury.gov/press-center/press-releases/Pages/tg1789.aspx

As Prepared for Delivery
WASHINGTON – Good morning and thank you to the OFR and the Council for the opportunity to join you here today.

It is a pleasure for me to note that this is the second annual conference hosted by the OFR and the Council.  These two organizations have come a long way since their creation in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Conferences like this one are a key way that the OFR and the Council are leveraging their expertise by calling on experts from academia, industry, and elsewhere in government to bring diverse perspectives on questions related to system-wide financial stability.

The Dodd-Frank Act designed the OFR to act as a catalyst to foster a broad examination of questions related to financial stability.  One of the OFR’s goals involves cultivating a virtual network of academics, researchers, and others to enrich and expand the OFR’s reach in fulfilling its mission.

The Council and the OFR work together to produce important and timely research and analysis on a range of issues—for example, on the risks presented by money market funds.  In addition, the OFR plays a central role in the international initiative to implement a global data standard to identify uniquely the entities in financial transactions.  This legal entity identifier, or LEI, is essential for governments and the financial industry to assess exposures and interconnections within the vast network of financial market participants.  And both the Council and the OFR have published detailed annual reports to engage the public with their work.

Today’s conference provides an opportunity to build on those accomplishments and to continue a discussion on the best ways to promote financial stability. 

The financial services marketplace is constantly changing, as market participants seek new and better ways to do business, as technology and techniques evolve, and as government adjusts the regulatory and supervisory framework.

This process of evolution creates exciting opportunities, but it also represents a moving target of possible risks that can grow into potential threats to financial stability.  That is where the Council and the OFR come in and that is where this conference will turn its focus.

Before the Dodd-Frank Act, the United States did not have one single agency tasked with looking at systemic risk across the financial system and considering how to respond to it – what we call a macroprudential approach.  That shortcoming resulted in a critical blind spot to risks building in the financial system and, once the crisis began, blocked a clear view of what was happening as the nation plummeted into the financial crisis.

The Council and the OFR are designed to correct that lack of comprehensive vision – to provide visibility across the financial services marketplace and across the areas of the compartmentalized responsibility of federal and state financial regulators.  It also allows us to inspect the inner workings of the financial system for an understanding of the interconnections that can transmit and compound systemic risks.

As 2012 draws to a close and Dodd-Frank implementation continues, our resolve is stronger than ever to resist any attempt to roll back these reforms and return our country to the precarious environment of misplaced incentives and inadequate controls that got us into such serious trouble.

We must also be mindful that, as the economy continues to recover, we must remain vigilant about detecting emerging risks and taking appropriate action.

In my experience, you are never handed the same script for a financial crisis or shock.  The next financial crisis is unlikely to look like the last.  Innovative thinking is essential as we recognize that the past approaches for assessing and managing system-wide risks are inadequate for facing the challenges of today and tomorrow.  New ideas must be applied to these problems and government cannot generate all of the good new ideas on its own.  There must be a partnership with academics, industry, and others—and conferences like this one are incubators for new ideas to emerge and begin to develop.

I would like to thank all of the conference participants for contributing to this effort and for helping to expand our collective knowledge of financial stability.  Your time and energies are providing a valuable service to our country, its economy, and its citizens.

###

Tracking Global Demand for Advanced Economy Sovereign Debt

Tracking Global Demand for Advanced Economy Sovereign Debt. Prepared by Serkan Arslanalp and Takahiro Tsuda
IMF Working Paper No. 12/284
December 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=40135.0

Recent events have shown that sovereign, just like banks, can be subject to runs, highlighting the importance of the investor base for their liabilities. This paper proposes a methodology for compiling internationally comparable estimates of investor holdings of sovereign debt. Based on this methodology, it introduces a dataset for 24 major advanced economies that can be used to track US$42 trillion of sovereign debt holdings on a quarterly basis over 2004-11. While recent outflows from euro periphery countries have received wide attention, most sovereign borrowers have continued to increase reliance on foreign investors. This may have helped reduce borrowing costs, but it can imply higher refinancing risks going forward. Meanwhile, advanced economy banks’ exposure to their own government debt has begun to increase across the board after the global financial crisis, strengthening sovereign-bank linkages. In light of these risks, the paper proposes a framework— sovereign funding shock scenarios (FSS)—to conduct forward-looking analysis to assess sovereigns’ vulnerability to sudden investor outflows, which can be used along with standard debt sustainability analyses (DSA). It also introduces two risk indices—investor base risk index (IRI) and foreign investor position index (FIPI)—to assess sovereigns’ vulnerability to shifts in investor behavior.

Operationalising the selection and application of macroprudential instruments

Operationalising the selection and application of macroprudential instruments
Committee on the Global Financial System
December 3, 2012
http://www.bis.org/press/p121203.htm

The recent financial crisis has accelerated efforts to develop macroprudential policy frameworks. As a result, new or strengthened mandates for macroprudential policies have been established in a growing range of jurisdictions. A report released today by the Committee on the Global Financial System (CGFS) provides practical guidance for policymakers on how macroprudential instruments should be chosen, combined and applied.

This report - prepared by a Working Group chaired by José-Manuel González-Páramo, formerly of the European Central Bank - aims to help policymakers in operationalising macroprudential policies.

Specifically, it identifies three high-level criteria that are key in determining the selection and application of macroprudential instruments:

1. the ability to determine the appropriate timing for the instrument's activation or deactivation;
2. the instrument's effectiveness in achieving the stated policy objective; and
3. the instrument's efficiency in terms of a cost-benefit assessment.

In trying to operationalise these criteria, the report proposes a number of practical tools that can help when choosing and implementing macroprudential instruments.

William C Dudley, CGFS Chairman and President of the Federal Reserve Bank of New York, says in the preface of the report: "We hope that the practical approaches described in this report will prove to be a relevant and timely input to the macroprudential policy frameworks that are currently being established in a large range of jurisdictions."

Human Nature: Jim Sinegal Dividend Tax Decision - Costco Will Borrow To Pay Dividends

Costco's Dividend Tax Epiphany. WSJ Editorial
Obama's fans in the 1% vote to beat Obama's tax increase.The Wall Street Journal, November 30, 2012, on page A14
http://online.wsj.com/article/SB10001424127887324705104578149012514177372.html

When President Obama needed a business executive to come to his campaign defense, Jim Sinegal was there. The Costco COST +2.07% co-founder, director and former CEO even made a prime-time speech at the Democratic Party convention in Charlotte. So what a surprise this week to see that Mr. Sinegal and the rest of the Costco board voted to give themselves a special dividend to avoid Mr. Obama's looming tax increase. Is this what the President means by "tax fairness"?

Specifically, the giant retailer announced Wednesday that the company will pay a special dividend of $7 a share this month. That's a $3 billion Christmas gift for shareholders that will let them be taxed at the current dividend rate of 15%, rather than next year's rate of up to 43.4%—an increase to 39.6% as the Bush-era rates expire plus another 3.8% from the new ObamaCare surcharge.

More striking is that Costco also announced that it will borrow $3.5 billion to finance the special payout. Dividends are typically paid out of earnings, either current or accumulated. But so eager are the Costco executives to get out ahead of the tax man that they're taking on debt to do so.

Shareholders were happy as they bid up shares by more than 5% in two days. But the rating agencies were less thrilled, as Fitch downgraded Costco's credit to A+ from AA-. Standard & Poor's had been watching the company for a potential upgrade but pulled the watch on the borrowing news.

We think companies can do what they want with their cash, but it's certainly rare to see a public corporation weaken its balance sheet not for investment in the future but to make a one-time equity payout. It's a good illustration of the way that Federal Reserve Chairman Ben Bernanke's near-zero interest rates are combining with federal tax policy to distort business decisions.

One of the biggest dividend winners will be none other than Mr. Sinegal, who owns about two million shares, while his wife owns another 84,669. At $7 a share, the former CEO will take home roughly $14 million. At a 15% tax rate he'll get to keep nearly $12 million of that windfall, while at next year's rate of 43.4% he'd take home only about $8 million. That's a lot of extra cannoli.

This isn't exactly the tone of, er, shared sacrifice that Mr. Sinegal struck on stage in Charlotte. He described Mr. Obama as "a President making an economy built to last," adding that "for companies like Costco to invest, grow, hire and flourish, the conditions have to be right. That requires something from all of us." But apparently $4 million less from Mr. Sinegal.

By the way, the Costco board also includes at least two other prominent tub-thumpers for higher taxes— William Gates Sr. and Charles Munger. Mr. Gates, the father of Microsoft's MSFT -1.22% Bill Gates, has campaigned against repealing the death tax and led the fight to impose an income tax via referendum in Washington state in 2010. It lost. Mr. Munger is Warren Buffett's longtime Sancho Panza at Berkshire Hathaway BRKB 0.00% and has spoken approvingly of a value-added tax that would stick it to the middle class.

Costco's chief financial officer, Richard Galanti, confirms that every member of the board is also a shareholder. Based on the most recent publicly available data, they own more than 4.1 million shares and more than 1.3 million options to purchase additional shares. At $7 a share, the dividend will distribute roughly $29 million to the board, including Mr. Sinegal's $14 million—at a collective tax saving of about $8 million. Even more cannoli.

We emailed Mr. Sinegal for comment but didn't hear back. Mr. Galanti explained that while looming tax hikes are a factor in the December borrowing and payout, so are current low interest rates. Mr. Galanti adds that the company will still have a strong balance sheet and is increasing its capital expenditures and store openings this year.

As it happens, one of those new stores opened Thursday in Washington, D.C., and no less a political star than Joe Biden stopped by to join Mr. Sinegal and pose for photos as he did some Christmas shopping. It's nice to have friends in high places. We don't know if Mr. Biden is a Costco shareholder, but if he wants to get in on the special dividend there's still time before his confiscatory tax policy hits. The dividend is payable on December 18 to holders of record on December 10.

To sum up: Here we have people at the very top of the top 1% who preach about tax fairness voting to write themselves a huge dividend check to avoid the Obama tax increase they claim it is a public service to impose on middle-class Americans who work for 30 years and finally make $250,000 for a brief window in time.

If they had any shame, they'd send their entire windfall to the Treasury.