Peso Problems, Ruble Problems, Euro Problems and all Bhat
The Ruble is collapsing. This will do dramatic damage to the Russian economy, because many Russian firms have dollar denominated debts. This is a familiar story. Something similar happened in East Asian countries in 1997 and Russia in 1998. There is no good policy response, because defense of the Ruble based on extremely high interest rates (last I heard 17%) will also cause extreme distress.
I think that it is in Russia’s interests to impose capital controls, which will amount to allowing and forcing Russian firms to default but leave foreign creditors with no legal recourse. Imposing capital controls worked rather well for Malaysia in 1997 and Russia in 1998.
In this post, my interest is in why creditors lent dollars given the fact that Russian debtors would default if the Ruble depreciated. As used by economists, the phrase “peso problem” doesn’t just refer to the Peso. It is the argument that sample averages in available data can be very misleading indicators of expected values if there are rare large events. The example was devaluation of the Mexican Peso. This was back in olden days, when Mexican borrowers borrowed in Pesos and the Peso was pegged to the dollar. Peso interest rates were, nonetheless, higher producing what appeared to be a riskless profit opportunity. Then the Peso devalued. Milton Friedman is given credit for arguing, before the devaluation, that the apparent riskless profit opportunity was no such thing.
The bottom line is that rare extreme events can make it seem that riskless profits have been earned. I use “the bottom line” literally to refer to the profit or loss stated in a profit and loss statement.
It has been argued that people who manage other people’s money, have excellent reason to seek out (or if necessary create) peso problems. Until the extreme event occurs, there are high returns and low measured variance of returns (that is low sample variance in the sample of stuff that has already happened). Such a pattern is highly rewarded. If disaster comes later, it is too late to claw back bonuses. Bankers allegedly sometimes say “IBGYBG” that is “I’ll be gone, you’ll be gone.”
Dollar denominated loans to firms with revenues denominated in another currency are a way to recreate the Peso problem without pegged exchange rates. The knowledge that there is a risk of widespread default implies high interest rates on such loans. The fact that widespread default hasn’t occured implies high performance compared to ex post measured risk. Big bonuses.
Another example is a larger than optimal currency area, that is, the Euro block. The introduction of the Euro caused a huge increase in the flow of loans from Germany to Spain. The Peseta could not realign compared to the Deutschemark. But there could be widespread insolvency instead.
Default is often (typically ?) worse for creditors than devaluation. But fear of possible default in the distant future has not prevented massive foolish lending.
I think this could be the usual problem that people who manage other people’s money who are rewarded based on short run performance have strong incentives to push risk into the lower tail of the distribution. Rare huge disasters aren’t costly enough to them.
The WSJ reports that PIMCO’s Emerging Market Fund has been whacked by the bust up in the Russian bond market.
Is this an example “foolish lending”? No – it’s yield hungry investors. These are bonds, not loans. Is PIMCO to blame? I would say “no”.
The Junk market for energy credits is no different than Russian bonds. The Junk energy bonds went into retirement accounts. Many of these bonds are now at risk. Who’s to blame? The fall in crude? Wall Street? Or yield hungry investors?
The Fed created a bubble in junk credit. That was one of the stated objectives of the last 6 year’s of monetary policy.
Near zero interest rates on “safe” investments forced savers to take more risk. That money juiced up stock values and created a window for junk issuance (of all kinds – including Russia). This has the usual end, bubbles get tripped up by something sooner or later, and when they burst small investors pay the price.
Wash, rinse, repeat.
The WSJ article:
http://www.wsj.com/articles/a-pimco-emerging-market-fund-hit-by-russian-debt-bet-1418776408?mod=WSJ_hp_LEFTWhatsNewsCollection
Energy Junk:
http://www.forbes.com/sites/investor/2014/11/11/falling-oil-prices-take-a-toll-on-energy-sector-junk-bonds/
Following on to Krasting: I think this could be the usual problem that people who manage other people’s money who are rewarded based on short run performance have strong incentives to push risk into the lower tail of the distribution.”
Firms who employ people who manage other people’s money are evaluated by their clients based on performance relative to a benchmark. And most clients or potential clients chase performance. If Firm A invests in Russian bonds and outperforms Firm B for 3 straight years with high “risk-adjusted” returns over the course of those 3 years, capital will flow away from Firm B and to Firm A. Firm A is then likely to buy more of the things that attracted clients to it in the first place, i.e., Russian bonds, further driving down yields.
Yes, the managers at Firm A are going to get bigger bonuses until Russia blows up, but those bonuses come out of the firm revenues, which are directly tied to the assets they manage and the performance generated on those assets.
Also consdier that clients have a preference for liquidity and access to their money over locking it up over an extended period.
Is this the fault of the bonus/compensation structure at Firm A, or is it a natural outcome of performance chasing clients? And given client preference for liquidity, over what time frame should one evaluate performance?
As I see it the problem lies in the lack of new share issuance (apart from banks forced to issue more shares because of equity requirements) and the tax advantage given to debt versus equity. If the extra cash was being invested in shares, and turned into real non-financial investment everybody would have fewer problems.
BKrasting
you use the word “force” differently than I do. If someone pulls a gun on me, he can force me to do something by giving me the choice between that and death. Accepting near zero returns is not like death.
Those of us who tend to believe in free markets do not think that people have a right to favorable prices. If the market clearing real interest rate is near zero, the market relative price of future consumption is near one. This is bad for creditors as low wheat prices are bad for wheat farmers. That’s capitalism.
The argument that we must give financial investors** higher safe returns or they will blow up the economy again sounds to me a lot like extortion.
Low wheat prices don’t force former wheat farmers to take risks (say by not buying drought insurance). Unfavorable prices can force people simply to tighten their belts, grit their teeth, and accept that markets don’t always favor them.
M.Jed Well in the end the clients choose, so they must blame themselves. This isn’t really a separate issue. A client can think as follows
Firm A has higher “”risk adjusted””* returns, but they calculated bonuses based on performance this callendar year, so I suspect that they have a lot of lower tail risk which doesn’t appear in the supposed risk adjustment. So I go with B which rewards only with untransferable claims on firm B’s portfolio which can only be exercized after 10 years.
Now firm B doesn’t exist, so I think the question of whether it would find clients is academic.
* I don’t like “scare quotes” so I quote you and your scare quotes. The outoer quotes are my regular plain honest quote a guy quotes of you’re comment including your scare quotes.
** our family portfolio consists entirely of houses, so I am not a “financial” investor and sure don’t have any safe returns to put it mildly.
The clients should blame themselves, but the academics blame the asset managers for doing what the clients implicitly, if not explicitly, told them to do.
I used scare quotes because using your assumptions the risk-adjusted returns aren’t actually risk-adjusted. They’re ex post realized risk adjustments to the return stream, but using your framework it’s analogous to the guy who doesn’t buy homeowner’s insurance to lower his personal expenses congratulating himself for saving money each year his house doesn’t catch on fire. It doesn’t actually lower the risk.
Firm B doesn’t exist because clients don’t want to lock up their money with a single firm for 10 years before they can determine whether Firm B performed as hoped.
As we know from the rating agencies that analyzed MBS and CDOs, nationally, house prices never go down, so there is no safer return stream as long as you’re geographically diversified 🙂
Those of us who tend to believe in free markets do not think that people have a right to favorable prices. If the market clearing real interest rate is near zero, the market relative price of future consumption is near one. This is bad for creditors as low wheat prices are bad for wheat farmers. That’s capitalism.
Just to be clear, the market clearing real interest rate at the short-end of the curve has nothing to do with free markets or capitalism. The Fed sets this rate. And the rest of the curve, one could argue is closer to free markets and market clearing rates, except at some level it’s referenced off of the short-end of the curve. And the Fed’s QE policy that has engineered lower yields at the long-end of the curve also flies in the face of free markets.
market clearing includes the labor market too.
I don’t oppose the content of “”risk adjusted””. I understand scare quotes. I really meant I don’t approve of that clear conventional use of punctuation (the reason I disapprove is that it is too easy to mock an argument by putting words in scare quotes).
If I had to come up with phrase and couldn’t quote your scare quotes, I would write “supposedly risk adjusted” or “adjusted not to risk but to sample variance, which is a very poor measure of risk when there are peso problems.” After my second try, I am reconsidering my opposition to scare quotes which can save a lot of pixels.
I don’t think QE has had a noticeable effect on long rates. Notably the impacts of surprise announcements on bond prices have been tiny.
In any case, the public sector Fed buying long term Treasuries is flies in the face of free markets neither more nor less than does the Treasury selling them. The Fed buys only US federal government issued debt instruments. It makes no sense to say that the price of Treasury notes is different from what it would be if the Federal Government left the private sector alone.
I don’t think QE has had a noticeable effect on long rates. . . .In any case, the public sector Fed buying long term Treasuries is flies in the face of free markets neither more nor less than does the Treasury selling them.
First, I recommend you read this speech, which I’ll excerpt below: http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm
Second, the purpose of the Fed’s QE program is to manipulate rates. The purpose of Treasury selling bonds is to fund the government. Treasury, to the best of my knowledge, isn’t trying to manipulate rates (which I distinguish from mitigating the impact of issuance) by timing or sizing its issuance.
Relevant snippets from the link above:
“Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. . .
“Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. . . .
“How effective are balance sheet policies? After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. . . .
“Importantly, the effects of LSAPs do not appear to be confined to longer-term Treasury yields. Notably, LSAPs have been found to be associated with significant declines in the yields on both corporate bonds and MBS.. . .
“LSAPs also appear to have boosted stock prices, presumably both by lowering discount rates and by improving the economic outlook; it is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases. This effect is potentially important because stock values affect both consumption and investment decisions.
Well said M. jed.
We can debate the benefits of QE/ZIRP, but there is no debate that the Fed’s policies have distorted the free functioning of markets.
Yellen is aware that the current Fed policy has raised the risks of a bubble in junk bonds. She said this in July:
“High-yield bonds have certainly caught our attention. There is some evidence of reach for yield behavior.”
Five months later and the chips are falling.
http://blogs.marketwatch.com/capitolreport/2014/06/18/yellen-raises-concerns-about-high-yield-bonds/
The first Bernanke quote includes the word “should”. It is a hope not evidence. The only quoted statement by Bernanke relevent to our discussion is only “Generally, this research finds … the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points”.
Here I note first that his claim is weak. “Generally” can mean “I cherry picked the inconclusive literature citing only the papers which support my conclusion”. Second I stress that Bernanke’s specific claim refers to QE1
This was a program of asset purchases during a financial crisis and panic. My view is that QE1 had a big effect but QE 2-3.5 did not. I think you will notice that all research which claims QE had large effects will include QE1.
I don’t want to retype to much in a comment thread so here is a google search
https://www.google.it/?gfe_rd=cr&ei=XueSVN3pCsWH8QfD5IAg&gws_rd=ssl#q=waldmann+qe+robert&safe=off&start=10
Finally I note that, to do his job well, Bernanke must convince economic agents that the FOMC has the situation under control. As Fed chairman he absolutely isn’t allowed to speak frankly. His public statements are policy. He isn’t and shouldn’t be allowed to say “we don’t understand what effect our non standard policy has” or “we have failed to stimulate the economy so far and we are out of ammunition.” He is a brilliant economist, but treating his public statements as a free expression of the thought of a brilliant economist is like treating Fed open market operations as the investment strategy of a profit seeking investor.
BKrasting. You seem to think that there is something which the Fed could do which would not be distorting markets. The Fed buys and sells. It is involved in markets. You clearly imagine some policy which you call neutral or non distorting. I think you are arbitrarily giving this accolade to whatever policy you favor. I note, just for example, that Milton Friedman advocated constant observation and reaction by the FOMC. He did not advocate say eliminating the Fed nor did he advocate a FOMC which refrained from open market operations. I think you have a conceptual problem and should first decide what alternative you see to distorting markets and then try to explain to yourself why you think that your proposed open market operations are non distortionary.
Robert says:
“As Fed chairman he absolutely isn’t allowed to speak frankly.”
So, according to Robert, the Fed must lie to the public to be effective. And Robert is perfectly happy being lied to.
Actually Robert, all lies get exposed at some point. I can’t believe you said that.