Saturday, October 29, 2011

Inefficacy of Central Bank Interventions

Part of my article below actually appeared in the Hindu Business Line Link a few days back, made some additions to the original post and re-posting it.

Even after two decades when it was decisively established that the forces of invisible hand are far superior to the command and control structure in bringing about the economic growth and prosperity, the Central Bankers across the world have not stopped trying. Perhaps the human urge for power and to feel that he is in control of his surroundings may also be playing a part; the belief that they have the might and the power to control the business cycles and to do away with recessions is evident in the dramatic increase in their interventions in the asset markets this past decade and now with the global economy in a flux ever since the financial crisis of 2008 it has increased further. Like the financial derivatives, the asset classes (equity, commodity, fx, bonds and real estate) are derivatives on the real economy and hence their price action is just a forward looking reflection of the economic condition. Thus a high volatility in any one of these asset classes can be a harbinger of the perilous state of the economy and so ever since bouncing off the abyss in 2008-09 the Central Bankers and Planners try to control the behaviour of the asset class that starts to exhibit high volatility. 

With years of intervention we have reached at a crossroad where the Central Banks have completely lost their control over the only component of the asset market where they actually had one; “the yield curve”. This became apparent in the late 90s in Japan and then finally here in US, when the Fed after propping up the property market in lieu of the busted Nasdaq bubble tried to control the elephant from turning into a dinasour by increasing the Fed Funds Rate in June 2004, however it soon found that it has completely lost control over the yield curve as the graph below demonstrates:

Chart a
So from June 2004 to August 2005 the Fed funds rate increased from 1% to 3.75% however the 10 year yield was at best flat; result - the property boom couldn’t be slowed down and the elephant actually grew bigger leading to the ofcourse eventual dramtic collapse. So as is apparent from the graph above, the Fed lost control of the yield curve almost 6-7 years ago however even now the Central Banks are living in a cinderlla world as is apparent by the announcement of “Operation Twist”.

The recent announcement of the Swiss Central bank to peg the Swiss Franc against the euro shows how this contagian to control the asset markets is spreading like a wildfire and in turn leading to a mispricing of assets and thus aggravating the economic situation. Let me elaborate further by picking on this example, so to maintain this peg the Swiss Central Bank would have to print as many CHF as it would take. Now because of the peg the volatility in the CHF-EUR currency market would diminish however the question that one should ask is what would one do of the new swiss francs that have been created, well using that the market participants would buy more of bonds/stocks/commodities etc. and thus what happens is that volatility would spill over and add to the existing volatilities in other markets, in essence volatility is not destroyed, just transferred.

 To establish how the volatility from this currency pair has moved into the other asset classes, below are the charts of standard deviation (volatility in simple words) of the daily changes in the CHF-EUR currency pair pre and post the announcement of the peg and a similar chart for the equity pair of the Swiss Stock Index to the French Stock Index i.e the (SMI/CAC ratio) for the same two periods. Please note that in order to have a similar comparison with a "currency pair" it's important to pair the Swiss market with a major Euro market as this would remove the effects of the volatility due to the broad common macro moves thus bringing about clearly the volatility impact due to the currency peg, also I am excluding the market data on the announcement day as we are interested in what happens "pre" and "post" peg announcements.

Chart b

Chart c

 A brief glance at these charts would tell you that even though the Swiss Central Bank was succesful in reducing the volatility of the CHF-EUR currency pair, however the unforseen impact of their action has been that part of the currency market volatility has moved into the Swiss stock market as exhibited by the volaitlity of the SMI/CAC ratio which has almost doubled post currency peg announcement

All this shows the ineffectiveness of the actions of the Central Banks as not only the volatility from one asset class moves to the other asset class thereby keeping the overall volatility in the system as same but excess of control would mean the volatility entering into the broad economy which is precisely what they intended to control to start with and so instead of taking the signal from the asset class exhibiting high volatility their actions leads to a mispricing of assets and thus aggravating the economic situation. 

Tuesday, October 18, 2011

The cries of Plutus – Why Greece should exit the Euro

With each passing day the Greek economy is pushed deeper into to the abyss, a country halted by strikes; people burdened with taxes; a government saddled with debt and a nation with uncertain fate.

Not only is it unfair for the common Greek citizens to pay for the folly of the bankers but living under a flawed economic structure – “The Euro” that is destined to create disparity instead of parity, they are also paying for the misjudgments and hubris of their politicians and economic elites.

A single currency area is equivalent to a monopolised business where the consumer is at the mercy of the industrialist only that this type of system can be termed as a "foreign social monopoly”. As one can see that the name itself encapsulates all the possible social and economic evils. By giving away the right to the printing presses not only the Greeks and other European countries have given away their economic fates to foreign masters but have also possibly given away their democratic ethos.

Let me elaborate, a currency may be a store of value for an individual but for a society at large it is nothing but a way to transfer wealth. Remember a currency is nothing but a short term government liability and so a currency note printed by the Central Bank and given to banks increases the assets of the banks but at the same time increases the liabilities of the government by an equal amount, so net impact on global wealth; “zero”. However this increase in government liability now has to be serviced by ordinary citizens; and how do we expect the citizens to service it…. Well by either putting in more hours than usual at work at same pay or giving away more from their existing share of their income to the government in form of taxes. The net effect of this whole guerilla circus is that the citizens end up giving more of their personal income to the banks in form of taxes or in form of harder workload.

So an increase or decrease in the currency supply doesn't actually change the overall wealth of the society; it simply moves it from one person to the other. This phenomenon of wealth transfer is quite apparent and common these days when the Central Banks prints a lot of money so let me explain what happens when this supply reduces.

So let’s assume that 2 people A&B have one euro each and vie for a product, they both can acquire it for a euro each. Now as fate would have it, A loses his euro; it simply vanishes from the world, has the world become poorer... NO, as now B can buy two of the same product with his euro, in other words wealth has not been destroyed, just transferred from person A to person B. Governments and Central banks already have monopoly over money creation and thus can easily transfer wealth these days by creating money (here capital owners and debtors benefit over labours and savers) or by destroying it.

By giving away the power to print money this transfer of wealth is now happening not just between individuals but also between countries in Europe. Euro on a consolidated basis is a weaker currency for Germany and a much stronger currency for Greece in other words there are too few euros for Greece and too many for Germany, remember a loose currency transfers wealth from labour to holders of capital and strong currency transfers it back to the labour.

So with such a strong currency there is little incentive for the capitalists in Greece to setup industries and employ people as a result the government ends up employing too many people (over 40% is government contribution to Greek GDP) and government true to its nature ends up making lofty promises, running exorbitant debt that now it cannot repay. Such a condition is advantageous for a country like Germany; this is not to say that Germany and German workers are not good at their work but this provides an even extra edge as with little competition from Greek internal industries it ends up selling lots of its products.

Had Greece been able to use its drachma it would certainly have devalued its currency by printing more money and thereby transferring some of the wealth from its labour to its capital holders, thus unleashing the country’s entrepreneurial spirit and giving an incentive for more people to start industries.

A monopolised currency system in any case is flawed but a common currency area is structurally and economically wrong and as we are seeing today has disastrous consequences. This would never lead to convergence but always a divergence away from the normal equilibrium. The leaders must accept their past mistakes and bring an end to this euro experiment else it will not just bankrupt many nations and benefit just a few but it could seriously jeopardise not just our economic but even our democratic setup. It was this land of acropolis which was the cradle of our modern day democratic system; today Greece should again pick the baton to preserve the same very values that it stood for. It’s time for Greece to exit this common currency experiment and in the process pave the path for others to follow.