I’ve got some excellent articles this week. Two papers on trading markets around events: one on equities and FOMC and one on bonds and auctions. Some good papers on how business cycles and monetary policy spills over from big countries to smaller ones. Another on the difference between the financial cycle and the business cycle. I have a bunch of articles on the growing “Cold War” rivalry between the US and China. And there a few on inequality. Finally, the FT has its recommendations for best econ books of 2018.
INVESTING and TRADING
The Periodic Table of Investments “All ordinary matter in the universe is comprised of chemical elements. An investment portfolio is no different, with a tapestry of asset classes, factors, strategies, tools and techniques serving as the raw materials.” Really cool periodic table of the investment universe!
The Pre-FOMC Announcement Drift: More Recent Evidence The Fed had previously documented large excess returns on equities ahead of scheduled announcements of the Federal Open Market Committee (FOMC)—the Federal Reserve’s monetary policy-making body—between 1994 and 2011. This post updates our original analysis with more recent data. We find evidence of continued large excess returns during FOMC meetings, but only for those featuring a press conference by the Chair of the FOMC.
Trading ahead of treasury auctions – This ECB paper looks at the gradual bond price decrease observed in the days leading up to anticipated asset sales such as Treasury auctions. In the model, risk-averse investors expect an uncertain increase in the net supply of a risky asset. They face a trade-off between hedging the supply uncertainty with long positions, and speculating with short positions. As a result of hedging, the equilibrium price is above the expected price. As the supply shock approaches, uncertainty decreases due to the arrival of information, investors hedge less and speculate more, and the price decreases. In line with these predictions, meetings between the Treasury and primary dealers, as well as auction announcements, explain a 2.4 bps yield increase in Italian Treasuries.
BUSINESS and FINANCIAL CYCLES
Measuring financial cycle time Clever paper separating the financial cycle (credit+housing) from the business cycle. The BIS finds that the duration of financial cycles varies and is generally longer than the duration of business cycles (see chart), the synchronicity of financial and business cycles appears fairly low and the business cycle does not appear to drive the financial cycle. However, there is a relationship between financial bust phases and serious macro-financial disruptions. They find that long-term real rates, inflation volatility, credit spreads and VIX are the key drivers of the length of the financial cycle.
Business cycle duration dependence and foreign recessions The ECB crunches the numbers on the G7 business cycle. They find that expansions in the US and Germany are more likely to end as they grow older (not so other G7). With respect to expansions in any G7 country, they find that the probability they end roughly doubles each time another G7 country falls into a recession. With respect to recessions in a G7 country, they find that the likelihood of them coming to an end is not affected by other G7 countries’ recessions. They also find that for all G7 countries that recessions that have gone on for a while are more likely to end.
How to manage failures of non-systemic banks? A review of country practices The BIS reviews the bank insolvency regimes of twelve selected jurisdictions, the paper identifies and discusses key features of bank-specific regimes that address the special nature of banking and the public interest considerations that may arise in the insolvency of any bank. They conclude, timely and fast-moving insolvency proceedings better preserve asset value, thus better protecting preferred claims of depositors, in particular by maximising the assets that are available to cover those claims.
Has Inflation Sustainably Reached Target? Fed paper argues that most of the increase in PCE inflation towards the Fed’s target can be attributed to “acyclical” factors (like healthcare, financial services and clothing) and are not due to a strengthening economy. While risks to the outlook for inflation appear broadly balanced, they include the considerable possibility that inflation has not yet sustainably reached target.
Explaining Monetary Spillovers: The Matrix Reloaded The BIS looks at interest rate spillovers to 47 advanced and emerging market economies. They find strong spillovers originating from the Federal Reserve and the European Central Bank. Spillovers from other advanced economy central banks (including the Bank of England and the Bank of Japan) are mild. Spillovers are more much prevalent for long-term interest rates, while short rates do not consistently respond to foreign monetary policy news. These effects tend to be larger for advanced economies, which are well integrated in global capital markets, than they are for emerging market economies.
Does a big bazooka matter? Central bank balance-sheet policies and exchange rates Solid ECB paper that finds QE by Fed and ECB did impact EUR/USD. For example, their estimates imply that the ECB’s APP program which raised the ECB’s balance sheet relative to that of the Federal Reserve by 35 percentage points between September 2014 and the end of 2016 depreciated the EUR/USD by a 12%. Regarding transmission channels, they found it worked by reducing euro-dollar short-term money market rate differentials, by widening the cross-currency basis and by eliciting adjustments in currency risk premia.
Silent Inflation Interesting piece by Robert Shiller. Inflation targeting is supposed to reduce uncertainty about prices. But keeping the inflation target at 2% or more, might actually increase a sense of uncertainty about real things like home values or investments.
Sources of borrowing and fiscal multipliers This paper finds that debt-financed fiscal multipliers vary depending on the location of the debt buyer. In a sample of 33 countries fiscal multipliers are larger when government purchases are financed by issuing debt to foreign investors (non-residents), compared to when they are financed by issuing debt to home investors (residents). In a theoretical model, the location of the government creditor produces these differential responses through the extent that private investment is crowded out. International capital mobility of the resident private sector decreases the difference between the two types of financing both in the model and in the data
FX and RATES
Currency depreciation and emerging market corporate distress BIS looked at the period 2014 to 2016 and found that EM firms borrowed in US dollars and accumulated cash in domestic currency were most vulnerable to a depreciation of the domestic currency against the dollar. In effect, they were engaged in a carry trade funded with dollars.
BAT Signals from Asset Markets: Estimating the U.S. Dollar Response to a Destination-Based Cash-Flow Tax A border-adjusted tax (BAT), would exclude exports from taxable revenues and exclude imports from allowable deductions, was mooted as an early policy by the incoming Trump administration. However, the economic implications of switching to a BAT depended crucially on how the exchange rate would respond. Studies varied on the magnitude of a dollar appreciation – with some arguing for a full offset. This Fed paper looks at the market pricing of the passage of BAT bill and finds the market was expecting the dollar to increase by less than half of any border tax.
Accounting for Macro-Finance Trends: Market Power, Intangibles, and Risk Premia Real risk-free interest rates have trended down over the past 30 years. Puzzlingly in light of this decline, (1) the return on private capital has remained stable or even increased, creating an increasing wedge with safe interest rates; (2) stock market valuation ratios have increased only moderately; (3) investment has been lackluster. They find that rising market power, rising unmeasured intangibles, and rising risk premia, play a crucial role, over and above the traditional culprits of increasing savings supply and technological growth slowdown.
How does monetary policy affect income and wealth inequality? Evidence from quantitative easing in the euro area The ECB finds that its policies did not lead to increasing inequality “we find that nonstandard monetary policy has only negligible effects on wealth inequality. In contrast, monetary policy compresses the income distribution since many households with lower incomes become employed”. Not surprising result coming from the ECB itself!
How Do War Financing Strategies Lead to Inequality? A Brief History from the War of 1812 through the Post-9/11 Wars The findings suggest that government borrowing to pay for wars leads to greater social inequality in the aftermath of the war. This happens when wars are paid for via general public debt versus a war bond campaign, particularly when combined with indirect taxes (such as sales, value-added, excise, and customs taxes) or a tax cut. Conversely, wars financed via bond campaigns targeted to low- and middle-income populations and direct taxes (such as income, property, and corporate taxes) result in greater social equality.
Financial structure and income inequality This BIS paper empirically investigates the link between financial structure and income inequality. Using data for a panel of 97 economies over the period 1989-2012, they find that the relationship is not linear. Up to a point, more finance reduces income inequality. Beyond that point, inequality rises if finance is expanded via market-based financing, while it does not when finance grows via bank lending.
Inequality and relative saving rates at the top The ECB estimate the long- and short-run relationship between top income and wealth shares for France and the US since 1913. They find strong evidence for a long-run link between the two governed by relative saving rates at the top. For both countries, they estimate a decline in the relative saving rates at the top – after 1968 in France and 1983 in the US. This has helped reduce the gap wealth and income inequality compared to the period before. Using counterfactual simulations, they find that the recent rise in wealth inequality in the US is largely attributable to the contemporary increase in income inequality. Modest income concentration dynamics and a stronger decline in relative saving rates at the top than in the US contributed to a more subdued rise in wealth inequality in France.
METHODOLOGY and PRIMERS
Partisan Professionals: Evidence from Credit Rating Analysts Partisan bias affects the decisions of financial analysts. The authors show that analysts who are not affiliated with the U.S. President’s party are more likely to downward-adjust corporate credit ratings. Their approach compares analysts with different party affiliations covering the same firm at the same point in time, ensuring that differences in the fundamentals of rated firms cannot explain the results. The effect is more pronounced in periods of high partisan conflict and for analysts who vote frequently. Their results suggest that partisan bias and political polarization create distortions in the cost of capital of U.S. firms.
How researcher rankings and research funding instruments can gain from information about co-authorship networks Through collaboration networks, researchers create spillovers for one another, and also other researchers indirectly linked to them. This column leverages co-authorship network data for economics to study the impact of these spillovers on total research output. Taking account of spillovers, the results show that the most productive researchers are not those with the most citations. Current funding schemes appear to be ill-designed to take advantage of the spillover effects generated in scientific knowledge production networks.
How to Read a Regression Great intro to the nuts-and-bolts of regressions from an Econ prof: “One thing I’ve found is that the students, even those who have taken econometrics or statistics classes before, really benefit from an explanation of how to read regression results — what exactly all the numbers you find in a regression table actually mean.”
Catastrophe Bonds: A Primer Useful in the age of climate change.
DB.NOMICS – the world’s economics database Excellent resource that gets data from 45 providers, 13,796 datasets and 414,710,163 series (and many more to come).
China’s Real Estate Market Great background paper on Chinese housing. “Since the 1990s, China’s real estate market has experienced a dramatic and long-lasting boom across China. This boom has led to substantial concerns in both academic and policy circles that the rising housing prices might have developed into a gigantic housing bubble, which might eventually burst and damage China’s financial system and economy. Motivated by this concern, this paper reviews the historical development of China’s real estate market, describes the real estate boom, and discusses its links to households, local governments, firms and the financial system.”
Chinese Communist Party needs to curtail its presence in private businesses China’s private enterprises are becoming more like state-owned ones as they set up internal party cells and other political organisations. Reducing Communist Party interference could help increase efficiency. Worth reading with this (Google translated): “Regulations on the Work of the Communist Party of China (Trial)”
Clock ticks for Chinese provinces struggling to hit their 2018 growth targets 19 of 31 provinces and municipalities were behind in meeting their annual goals after third quarter. Provincial officials facing race to pump up their local economies to bolster their promotion chances
How the Belt and Road Initiative could reduce trade costs The Belt and Road Initiative, proposed by China in 2013, consists primarily of a series of infrastructure projects aimed at improving connectivity on a trans-continental scale. The column presents new evidence on the potential impact of the initiative on trade costs. It shows that through a reduction in shipment times, the initiative could substantially reduce trade costs for participating countries, with positive spillover effects on the rest of the world.
China’s Monetary Policy Communication: Frameworks, Impact, and Recommendations – This IMF paper discusses China’s unique institutional setup and empirically analyzes the impact on financial markets of the PBC’s main communication channels, including a novel communication channel. The results suggest that there has been significant progress but that PBC communication is still evolving toward the level of other major economies. The paper recommends medium-term policy reforms and reforms that can be adopted quickly.
MILITARY and NEW COLD WAR
Providing for the Common Defense The US’s National Defense Strategy Commission wants more funding for the US military: “Today, changes at home and abroad are diminishing U.S. military advantages and threatening vital U.S. interests. Authoritarian competitors—especially China and Russia—are seeking regional hegemony and the means to project power globally. They are pursuing determined military buildups aimed at neutralizing U.S. strengths”. Also worth reading Is civilian control of the military eroding? which focuses on one counterintuitive finding in the commission’s report. It described relations between the uniformed military and civilian leadership of the Pentagon as somehow out of whack.
China Militarizes Its Influence in Africa Discusses the China Africa Defense and Security Forum (CAFSF) and the growing Chinese military presence in Africa. warning.
Managing American Decline Reviews a new book “In Twilight of the Titans”,where two scholars analyse the rise of new powers and decline of old powers since the 1800s. They find “that most states respond sensibly to relative decline, undertaking prompt, proportionate retrenchment, because they seek strategic solvency—they don’t want to go bankrupt”, while ““premature bids for hegemony can not only encourage the formation of hostile foreign coalitions but also upset the fragile domestic foundations of long-term growth.”. A warning for both the US and China.
China pins its hopes on beating US in race for bio-intelligence supremacy Beijing invests heavily in the hope that AI combined with genomics will give it a vital edge over America. Technology could give rise to massive shift in global power and pave the way for forms of ‘cyber-colonisation’
Pockets of risk in European housing markets Loan-to-value limits and other borrower-based macroprudential measures are now used in two-thirds of advanced economies. This column uses survey data to document changes in credit standards in a cross-section of countries in the run-up to, and aftermath of, the financial crisis. There is clear evidence of laxer credit standards in countries that experienced a real estate boom-bust, and a significant tightening after the bust. The results imply that compared to earlier years, younger and lower-income borrowers have to save for longer before buying.
Angela Merkel’s New Momentum Since German Chancellor Angela Merkel announced that she will not seek another term and will step down as her party’s leader at the end of this year, political obituaries have been rolling in. But far from bowing out quietly, Merkel will use her remaining time in office to cement her legacy as a defender of the European project.
Brexit Referendum and Business Investment in the UK In this IMF paper, the author applies firm-level analysis to examine how the Brexit process has affected business investment in the UK. The results suggest that potential trade costs have had a considerable and statistically significant negative impact on firm investment in the UK after the referendum. At the same time, the post-referendum sterling depreciation has likely contributed positively to investment expenditure by more foreign-oriented firms.
Populism and Civil Society – Populists claim to be the only legitimate representative of the people. But what about civil society? The paper ask two questions: 1) do individuals who are members of civil associations vote less for populist parties? 2)does membership in associations decrease when populist parties are in power? They look at the experiences of Europe, which has a rich civil society tradition, as well as of Latin America, which already has a long history of populists in power. The main findings are that individuals belonging to associations are less likely by 2.4 to 4.2 percent to vote for populist parties, which is large considering that the average vote share for populist parties is from 10 to 15 percent. The effect is strong particularly after the global financial crisis.
Sludge and Ordeals In 2015, the United States government imposed 9.78 billion hours of paperwork burdens on the American people. Many of these hours are best categorized as “sludge,” reducing access to important licenses, programs, and benefits. Because of the sheer costs of sludge, rational people are effectively denied life-changing goods and services; the problem is compounded by the existence of behavioral biases, including inertia, present bias, and unrealistic optimism. In principle, a serious deregulatory effort should be undertaken to reduce sludge, through automatic enrollment, greatly simplified forms, and reminders. At the same time, sludge can promote legitimate goals such as serving as a rationing device, ensuring that benefits go to people who most need them. For sludge, a form of cost-benefit analysis is essential, and it will often argue in favor of a neglected form of deregulation: sludge reduction.
Alexandria Ocasio-Cortez’s Twitter Presence Is a Blueprint for 2020 Democrats Pivot to policy, every single time.
Best books of 2018: Economics FT’s ”best of” list