How to Save the Euro? Lessons from the US

by Jacques Melitz © VoxEU.org

Earlier this year, the fiscal situation in Greece caused turmoil across Europe. This column examines why the financial difficulties of several state governments in the US are not having similar impacts on its economy.

The problems of the Eurozone this year brought to light some failures of the system. Nevertheless, the resulting drop in confidence in the system has gone further than we might have expected. Questions have even arisen about the survival of the system (see Baldwin 2010 and Blejer and Levy-Yeyati 2010 for discussions). Yet monetary systems do not tend to dissolve simply because of faulty performance. On the contrary, as a rule they endure even when they function very badly. It takes a political force majeure to bring about the break-up of a single currency area, typically without connection to monetary performance. Why, then, has the possible default of a country engaged in irresponsible fiscal policy and accounting for only 3% of the Eurozone’s GDP raised questions about ‘saving the euro’ and the survival of the Eurozone?

The issue has not received the attention it deserves. It is often simply taken for granted that the departures from the Stability and Growth Pact provide a sufficient reason for the earthquake that has shaken the whole currency area. Yet if we look around the world past and present, the mismanagement of finances by regional governments has no particular tendency to bring down entire monetary systems, far from it. In line with the usual – I think superficial – diagnosis of the ailment, proposed remedies for the Eurozone centre on strengthening the Pact, increasing joint political control over fiscal policy, and providing joint insurance against government default, or some mixture of the three. But what if a vital element of the problem is really the official doctrine that sovereign default is incompatible with the euro? What if the scale of the crisis that took place this year has resulted from financial markets’ conviction, based on this doctrine, that the future of the euro was at stake? What if assuring the long-run sustainability of the euro means convincing those markets, quite differently, that nothing as manageable as a Greek default can upset the Eurozone?

Lessons from the US

That is precisely what the US example would suggest and what I will defend. With this idea governing beliefs, the right road ahead looks quite different. It means shifting the emphasis away from avoiding government defaults toward assuring the stability and the solvency of the banking system at all times, regardless of the financial difficulties of some member governments.

In the US, default on state and municipal contractual obligations is very much a possibility whenever lower-level governments are in financial trouble; bailout cannot be taken for granted. New York City defaulted in 1975, the biggest default of all by a lower-level government unit since World War II took place in 1983 when the Washington Public Power Supply System went into bankruptcy, and Orange County defaulted in 1995. Various municipal governments have been on the verge of default at times in the last few decades, including Philadelphia and Cleveland. There is also no Stability and Growth Pact in the US. Yet financial discipline is considerably higher in the US at the state government level than in the Eurozone at the national level. All states except Vermont have balanced-budget rules; but these rules are self-imposed. It is easy to argue that this difference in fiscal discipline on the two sides of the Atlantic is related to the fact that when push comes to shove in the US and a lower-level government unit cannot or will not meet its debt obligations, the lenders can expect to take a big part of the hit.

Some rudimentary analysis is relevant. Consider any government unit unable to print money and without any prospect of a bailout. Theory tells us that credit rationing is very much a possibility. As the interest rate that such a government offers on its debt goes up, extra lending dries up completely at some point as the expected rate of return on the government debt falls. This must happen because higher nominal interest rates impair the government’s solvability and bring default nearer. Risk aversion simply lowers the interest rate at which credit rationing begins.

Suppose we compare the situation in the US and the Eurozone since the 2007-2009 financial crisis in this light. The crisis brought about dire financing problems for many lower-level government units in the US and some national governments in the Eurozone. According to the spreads on credit default swaps, California and Illinois now have a higher probability of non-performance on public debt than Portugal and Spain. This has been true for months. Consider next the difference in response in the States and Europe. Recently Illinois simply stopped paying $5 billion of bills. In June of last year California issued vouchers for wage payments. In addition, savage cuts in public services have begun and are now threatened in various states in difficulty, not only these two. Nevada has made startling reductions in spending on higher education and welfare. In the case of Portugal and Spain, nothing so drastic has happened thus far. There have been occasional spikes in interest rate spreads over German bunds of 100 to 200 percentage-points above usual levels. Both Spanish and Portuguese governments have also been forced to plan greater austerity and reduced government deficit spending. Meanwhile, they have been able and willing to keep borrowing.

Why the difference between the Eurozone and the US?

Part of the explanation may be that Portugal and Spain are more able to raise tax revenues than US states. But another part is the higher probability of a bailout in Europe. The example of Greece is to the point. Greece has been able to continue borrowing this year at interest rates typically around 200 percentage-points above Portugal and Spain on 10-year government bonds (and since May more than 500 percentage-points higher than German bunds). If you do the math, it is clear that this could never have happened without a high probability of a bailout. In fact, you do not need to do the math: there have been occasions in February/March and particularly May when some Greek issues would clearly have failed without the assurance of public lending and ECB support. If Greece can borrow on the probability of a bailout, so could Portugal and Spain.

Based on this evidence, the current Eurozone strategy of treating government default as anathema permits member governments to sink into deeper waters, weakens the forces that would otherwise exist toward self-imposed budget restraints, and thereby raises the probability of a bailout. But an actual bailout is perhaps the most likely setting for the breakdown of the Eurozone. If taxes ever need to rise all over the Eurozone in order to bail out a member government, one can easily imagine a pullout by Germany, followed by the Netherlands and Austria (if no others), in order to form a separate monetary union.[1]

What are the dangers of the opposite strategy of mimicking the US instead and moving toward heavier reliance on markets to discipline member governments and to price sovereign risk? The answer lies in the external effects of government default on the payment system and the banks, and this problem would be aggravated by contagion. But those dangers exist in the US as well. If the US federal government were to allow Illinois or California to default on state government debt in today’s circumstances of widespread financial difficulties across the states, there is a serious threat that interest premia would go up on the debt of most state governments and a wave of state defaults would follow. For this reason, the federal government might well step in. But if we look at the institutional manner in which the US deals with the problem, we find the answer to lie in country-wide prudential rules for banks and central bank powers of lender of last resort. There is no general announcement that state government default is incompatible with the dollar. Instead there is a strict separation of the issue of joint support of the financial system and joint support of financing by the sub-government units in the country. Would Europe not be wise to adopt the same strategy and to cease to conflate the two issues?

Tweaking the Pact

What this would mean, of course, is adopting Eurozone-wide prudential rules on banks, providing the ECB full powers of lender of last resort, and, very significantly, dismissing the idea that the Stability and Growth Pact is the pillar on which the whole Eurozone project stands. This idea is highly perilous.[2] Markets believe it, and at times of financial precariousness, what markets believe is extremely important. According to my proposal, the Pact could still be upheld as a code of good behaviour which improves public finances in Europe and facilitates the task of the ECB. But the basic philosophy would be that if any individual member government in the Eurozone engages in irresponsible fiscal conduct, contrary to the Pact, the creditors and its taxpayers would bear the brunt of the consequences. Everything would be done to assure the stability of the financial sector in the Eurozone and the lack of repercussions on the risk premiums that the more financially responsible member governments need to pay. Banks might be bailed out but not governments. Any aid to member governments, if it came, would not concern the euro system but the IMF or if any aid did come from the EU it would be part of a programme that could as well have existed had the euro never appeared and would be clearly sealed off.

VoxEU Editors' note: This article will appear as a roundtable discussion in Miroslav Beblavy, David Cobham and Ludovit Odor, eds., The euro area and the financial crisis, Cambridge University Press, forthcoming.

References:

Baldwin, R (2010), A re-cap of Vox columns on the Eurozone crisis” VoxEU.org, 13 May.

Blejer, M and Levy-Yeyati, E (2010), Leaving the euro: What’s in the box, VoxEU.org, 21 July.

Economist (2010), Can pay, won’t pay, June 19.

Poterba, J (1996), Do budget rules work? NBER Working Paper 5550, April.

Public Bonds (2010), Municipal bonds and defaults, downloaded 23 August.

Reinhart, C M and Rogoff, K (2009), This time is different: eight centuries of financial folly, Princeton: Princeton University Press.

Sinn, H-W (2010), Rescuing Europe, CESifo Forum, special issue, August.

Notes:

[1] Many would say that Greece has already been bailed out. But so far no holder of Greek debt has yet suffered a credit event. Further, no one outside of Greece has yet paid any taxes to fulfil a claim on Greek debt. Thus, according to my usage, no bailout has happened. However, none of the argument hinges on this choice of words.

[2] If we really think that a government default would bring the euro under, we must conclude that the euro has no long-run future ahead – that it is doomed. A reading of Reinhart and Rogoff (2009) should convince anyone.

Republished with permission of VoxEU.org

What is "Junoon"...?

I just finished reading Razi Imam's new book, Driven: A How-To Strategy for Unlocking Your Greatest Potential (2010). According to Imam (pp. 46-47):

The word, Junoon, comes from the Urdu/Arabic language... The current English language lacks a single word to describe the concept, so the best we can do is describe it in three words: Junoon is a state of obsession. It's a trasnformative, all-consuming mania: a kind of craziness, if you will, that envelops your mind and heart to achieve yoiur goal.

To live within the state of Junoon is to concentrate passionately on realizing your mission and transcending day-to-day human motivation to a degree that seems impossible to those around you. Being in this state coalesces and magnifies your ordinary strength of will and determination, and turns you into a person who rises to challenges in ways that others can't even imagine. You hold nothing back. You put your all and everything that you do, and through your investment of your entire being, you find ways to surmount the most daunting of circumstantial barriers with incredible energy.

Imagine that you're so obsessed with accomplishing something for the greater good that you feel utterly consumed with getting it done. You are inspired by a mandate from the universe, and allow nothing to stop you from achieving your objective. From morning to night, you live within your passionate concentration and desire. This is what it's like to live in, and act from, the state of Junoon.

Anyone who has ever experienced Junoon during their lifetimes will quickly recognize themselves in this book. Junoon is a fascinating term and concept, which will likely find its way into the English lanaguage and lexicon.

Source: Imam, R (2010), Driven: A How-To Strategy for Unlocking Your Greatest Potential, Hoboken, NJ: John Wiley.

John R Talbott: The Real Reason Geithner Is Afraid of Elizabeth Warren

John Talbott's recent editorial expose (2010, The Real Reason Geithner Is Afraid of Elizabeth Warren) regarding his views on the underlying strategy driving current fiscal and monetary policies in the US is instructive for those seeking to better understand what is happening with the economy. Clearly, Federal Reserve chief Ben Bernanke and Treasury Secretary Tim Geithner are being less than transparent in their motives and intentions. In particular, their alleged strategy of rebuilding Wall Street at the expense of Main Street account holders is deflating America.

The times of elites like J P Morgan ruling over the US economy are behind us, and the American people are unlikely to tolerate these kinds of fiscal and monetary tactics and strategies over the long-term. We the people need better transparency from the Federal Reserve and Treasury Secretary in order to understand what is happening to our nation's economy.

Source: Talbott, J R (2010, July 18), The Real Reason Geithner is Afraid of Elizabeth Warren, Huffington Post.

Business Intelligence and Strategy

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Source: Williams, N (2011, March 2), Business Analytics & BI Strategy: What is the Mission? BeyeNetwork.

Small Investors Beware

High frequency (or algorithmic) trading was one of the major investment innovations to emerge in the late 20th century. Given the effectiveness and profit potential of such methods, it comes as no surprise to learn that 46 percent of daily volume originates through high frequency strategies.

Powerful computers, some housed right next to the machines that drive marketplaces like the New York Stock Exchange, enable high frequency traders to transmit millions of orders at lightning speed and, their detractors contend, reap billions at everyone else’s expense… High-frequency specialists clearly have an edge over typical traders, let alone ordinary investors… Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds… These systems are so fast they can outsmart or outrun other investors, humans and computers alike. (Duhigg, “Stock Traders Find Speed Pays, in Milliseconds,” NYT, 23 Jul 2009)

Unfortunately, the methods of high frequency trading are neither available nor assessable to the average investor. My advice to most investors is to invest in public companies only with funds that you can afford to lose. My recommended investment strategy of choice for serious investors is to target companies in which you are an active owner, partner, or director in order to ensure you have full access to the fundamental information you need to monitor your investments wisely (which incidentally is the same strategy apparently used by Warren Buffet, George Soros, and Carl Icahn).

Institutional investors and other major players dominate modern day investing with sophisticated methods and technologies that the average investor cannot hope to match. Unless regulators can find a way to level the playing field, small investors should beware of the markets.

Business Analytics: Going the Distance

Business analytics stratifies into three levels of inquiry and findings beginning with descriptive, followed by predictive, and finally prescriptive methods as follows:

Descriptive Analytics: A set of technologies and processes that use data to understand and analyze business performance.

1. Standard reporting and dashboards: What happened? How does it compare to our plan? What is happening now?
2. Ad-hoc reporting: How many? How often? Where?
3. Analysis/query/drill-down: What exactly is the problem?

Predictive Analytics: The extensive use of data and mathematical techniques to uncover explanatory and predictive models of business performance representing the inherit relationship between data inputs and outputs/outcomes.

1. Data mining: What data is correlated with other data?
2. Pattern recognition and alerts: When should I take action to correct or adjust a process or piece of equipment?
3. Monte-Carlo simulation: What could happen?
4. Forecasting: What if these trends continue?
5. Root cause analysis: Why did something happen?
6. Predictive modeling: What will happen next if?

Prescriptive Analytics: A set of mathematical techniques that computationally determine a set of high-value alternative actions or decisions given a complex set of objectives, requirements, and constraints, with the goal of improving business performance.

1. Optimization: How can we achieve the best outcome?
2. Stochastic optimization: How can we achieve the best outcome and address uncertainty in the data to make better decisions?

While descriptive analytics provide a starting point for understanding problems and performance, the more significant purpose and objective of analytics is to achieve predictive and prescriptive findings via higher levels of technique. Make certain that your business analytics strategy is not short-changing decision makers by concluding with descriptive findings alone. Said another way, insist that your business analytics leaders and teams have the training and discipline to go the distance into all forms of advanced analytical methods and techniques as required. The questions posed above under each level of inquiry can provide the interrogative tools for evaluating your firm's current capabilities.

Source: Lustig, I, Dietrich, B, Johnson, C, and Dziekan, C (2010, November-December), The Analytics Journey, Analytics Magazine, 11-18.

The Nordics in the Global Crisis

by Thorvaldur Gylfason, Bengt Holmstrom, Sixten Korkman, Hans Tson Söderström, and Vesa Vihriälä © VoxEU.org

Is the Nordic model an asset or a liability? The global crisis has seen GDP in the region decline by between 4.5% and 7%. This column argues that the Nordic model, with its welfare state and high rate of investment in human capital, can, properly implemented, be part of the solution.

The Nordic countries – Denmark, Finland, Iceland, Norway and Sweden – are champions of free trade and open markets. And for a good reason; they see international specialisation within a global framework as a means of raising productivity and income. Much of the Nordic socio-economic model can be interpreted as aiming at collective risk sharing with a view to fostering acceptance of open markets, new technologies and the need for change.

In a broad sense the model includes a set of labour market organisations, with an important role for negotiations, a comprehensive safety net and a high rate of publicly supported investment in human capital. Embracing globalisation and sharing risk are mutually reinforcing planks of the Nordic Model, as discussed in Andersen et al. (2007).

Is the Nordic model an asset or a liability?

The current crisis is not only a financial and economic crisis but also a crisis of the much heralded globalisation process itself. It therefore raises many key questions for small open economies, not least the Nordics. What are the lessons of the crisis for economic policies? Is the future of the global economy more unstable than the past, and does that perspective call for a fundamental review of the economic policy strategy? Is the Nordic model an asset or a liability in the light of the crisis?

As we discuss in our new report (Gylfason et al. 2010), the crisis is best seen as the outcome of a lopsided globalisation process that overwhelmed the global financial system. The global savings glut was largely absorbed by the US shadow banking system, because of its capacity to create innovative products. It seemed to offer safe investment outlets at attractive rates of return, while at the same time encouraging excessive leverage. Once the bubble burst and the world economy went down, the Nordics, with their high dependence on exports of investment goods and consumer durables, were particularly hard hit (with the exception of oil-rich Norway). Their GDP in 2009 declined at rates between 4.5% and 7%.

While the sharpness of the global downturn was a surprise, so was the early stabilisation, which started around the middle of 2009. At this point the recession has been declared over in many countries and a recovery – though weak and hesitant – seems to be underway. There is little doubt of the explanation; policies matter. Authorities have demonstrated an unprecedented activism in monetary and fiscal policy as well as inventiveness in financial crisis management. While the world escaped a repetition of the Great Depression, the crisis has nevertheless left a legacy of difficult issues and challenges.

The Nordics are vulnerable but also resilient. While Iceland is a case of its own, we believe that the Nordics have the capacity to recover and to continue combining economic efficiency with high social ambitions. Sweden and Finland experienced a severe banking crisis in the early 1990s, thereby learning a lot about the need for better financial regulation and supervision.

Lessons were learnt about the need for a solid crisis management framework, the pros and cons of a blanket government guarantee for financial institutions, the need for precautionary and other capital injections, the problems of transferring assets into “bad banks”, and the case for not shying away from the government taking over institutions in certain circumstances. Many of these lessons were useful in avoiding mistakes in this crisis and they have attracted interest in other countries. This is also why companies and banks in the region have had balance sheets strong enough to weather the crisis pretty well (we obviously leave out Iceland again).

The effect of the euro

The Nordics have all had different monetary regimes since the euro. Given their similarity in other respects, a comparison of Finland and Sweden is especially interesting. It is almost a laboratory experiment. Sweden has a floating exchange rate and an independent central bank geared to price stability, while Finland is part of the Eurozone. Who has made the better choice?

The krona was mostly stable and developments in Finland and Sweden were strikingly similar during the first decade of the euro. Once the crisis erupted, however, the krona fell significantly relative to the euro, thereby strengthening the price competitiveness of Sweden relative to Finland and the euro area. One might expect this to help Sweden come through the crisis at less cost than Finland, arguably benefitting at the expense of its neighbour by capturing market shares.

The decline in exports and output in 2009 was indeed smaller in Sweden than in Finland, and GDP growth is forecast to be somewhat faster. However, the differences do not seem large. Also, manufacturing output shows little response to the change in competitiveness, and unemployment is rising in parallel with developments in Finland.

Either the effects of the improved competitiveness are relatively modest or the lags are long, or a depreciation of a floating currency has less effect on export and output volumes than a devaluation of a pegged currency used to have. What is clear is that the floating exchange rate does not insulate an economy from external shocks, and the economic differences between the two exchange rate regimes seem smaller than often claimed in the heated debate about the Eurozone.

An effective fiscal stimulus?

For small and open economies, in particular, one may question the power of fiscal expansion as an instrument of demand management. Nevertheless, we still find that an expansionary fiscal policy is helpful in a crisis. It is a useful complement to monetary policy when the interest rate hits its lower bound or when the credit system becomes dysfunctional. Also, fiscal action may alleviate particular problems such as long-term or youth unemployment. Furthermore, automatic fiscal stabilisers allow the government to avoid hasty and unduly harmful measures. The social contract is very valuable in a crisis as it tempers the panic and gives the government more time to plan and undertake measures to reignite growth in an orderly manner.

Of course, sustainable public finances need to be restored, and it is useful to consider the merits of alternative means of fiscal consolidation. Public expenditure may be cut or its composition twisted in a growth-friendly direction, and efficiency in the provision of public services improved. The tax base may be broadened by measures to raise the employment rate, particularly by prolonging the length of working careers. There is some scope for changing the structure of taxation with a view to encouraging economic growth, notably by reducing the share of taxes that fall directly on corporate profits and wage income.

The Nordics were in a position to pursue fiscal expansion in the crisis because these countries were – in contrast to the US and almost all other EU countries –running sizeable budget surpluses in the preceding decade. The government debt level of the Nordics is only half of what it is in the OECD on average and they continue to borrow at very favourable terms. Given their track record, there is reason to believe that the Nordics will continue to be countries with relatively sound public finances, retaining the scope for fiscal policy to be used when needed.

Safety in numbers

Most importantly, the Nordic model itself contributes to resilience. The comprehensive safety net, one of the attributes of the Nordic model, has proved to be robust also in times of crisis. The entitlements are not tied to the fate of individual companies or particular markets, and risks are widely shared in the society. While forest plants are shutting down in Finland and car manufacturing is sharply contracting in Sweden, the governments are firmly rejecting requests for support of ailing industries. Still, there are no crowds protesting in the streets, largely because flexible work arrangements, based both on general and company-specific agreements between businesses and labour, alleviate a rise in unemployment. Structural change is enhanced by the employment protection legislation, which is more liberal than in most other EU countries. A well-educated labour force, another of the attributes of the Nordic model, facilitates adjustment by making it easier to upgrade skills through additional training.

Provided that governments continue to be able to take the decisions needed to safeguard competitiveness and the sustainability of public finances, the Nordic model can be both robust and resilient. The Nordic model with its welfare state, labour market institutions and high rate of investment in human capital, is not the source of the current problems. On the contrary, the Nordic model, properly implemented, can be part of the solution.

References

Andersen, T, Holmström, B, Honkapohja, S, Korkman, S, Söderström, H T, and Vartiainen, J (2007), ”The Nordic Model – Embracing Globalisation and Sharing Risks,” The Economic Research Institute of the Finnish Economy, Helsinki: ETLA.

Gylfason, T, Holmström, B, Korkman, S, Söderström, H T, and Vihriälä, V (2010), "Nordics in Global Crisis – Vulnerability and Resilience,” Helsinki: ETLA.

Republished with permission of VoxEU.org

The Future of Work is Serious Play

Writes Prof Jason Scott Earl in The Beginner (2012, Aug 30):

The great divide between the gaming community and management educators is quickly coming to a close. The past relationship between gamers and business management educators, whereby one dismissed the others based on what has now increasingly proven to be unsupported information, is changing. As research points out, there is a significant opportunity in adopting an engaging business simulation strategy and its potential impact on the world of management education. The truly disruptive innovation nature of online business simulations has the potential to dramatically impact emerging markets – such as online education – with new and more powerful ways of teaching and learning.

Read More

Prof Jason Scott Earl

Virtual learning environments are the future of learning. Firms such as Rosetta Stone are already pioneering new methods for distributing knowledge via simulation technology. Everything we know about education will change as virtual learning systems eventually supplant the classroom approach to instruction. Those changes will affect not only "bricks and mortar" classrooms, but the current notion of online course room structures as well. Computer learning systems are set to revolutionize education as we know it.

Source: Earl, J S (2012, Aug 30), The Future of Work is Serious Play, The Beginner.

Related Posts

The Tea Party's Pyrrhic Victory

According to Peter Coy of BloombergBusinessweek (2013, October 17):

In political terms, the Tea Party’s scorched earth strategy has produced some impressive legislative wins but damaged the movement’s popularity. Now its blunt tactics threaten to make deficit reduction seem like a fringe issue, one of concern only to extremists. The Greek king Pyrrhus, after whom Pyrrhic victories are named, once said, "If we are victorious in one more battle with the Romans, we shall be utterly ruined."

Read More

Source: Coy, P (2013, October 17), The Tea Party's Pyrrhic Victory, BloombergBusinessweek.

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Critical Modeling Strategy

In this occasional paper, I promote critical thinking by modelers in finance and accounting. In particular, I argue that reliability and validity checks are integral to the business modeling process.

Download

The Ten Commandments of Risk Analysis

The Ten Commandments of risk analysis according to Prof Granger Morgan and Prof Max Henrion (1990):

• Do your homework with literature, experts, and users
• Let the problem drive the analysis
• Make the analysis as simple as possible, but no simpler
• Identify all significant assumptions
• Be explicit about decision criteria and policy strategy
• Be explicit about uncertainties
• Perform systematic sensitivity and uncertainty analysis
• Iteratively refine the problem statement and analysis
• Document clearly and completely
• Expose to peer review

Business Analytics: Questions for Enterprise

Firms today are increasingly seeking competitive advantage through advances in business analytics and decision support systems. According to a white paper published by nGenera (2008) in collaboration with Prof Thomas Davenport:

The next wave of business reengineering is being powered by business analytics, and the potential performance breakthroughs are just as large as they were 15 or so years ago. Many of these breakthroughs will come through the ability to integrate the demand side of the house with the supply side of the house as never before. Even information-rich industries have tended to concentrate on one side or the other. With the power of business analytics, corporations can make and manage the demand-supply connections – a big step closer to the goal of optimizing the performance of the corporation as a whole.

Here are six topical questions (with supporting questions) posed by nGenera for companies seeking to compete analytically:

1. Where should we leverage business analytics?

• What is our distinctive capability? On what basis do we choose to compete? And how clear and definitive are we about that choice?
• What performance levels or innovations in this area would blow away the competition?
• What information, knowledge, and insight would it take to perform that way? What are the biggest unanswered questions and biggest opportunities?
• How would we act upon that information, knowledge, and insights.

2. Why now?

• What are our direct competitors doing or attempting with business analytics? Is anyone in our industry jumping ahead in terms of analytical capability?
• How are analytics changing our competitive landscape? Are we at risk from non-traditional competitors who may use analytics to encroach on our markets?
• What emerging technologies of information integration and analysis should we be exploring more aggressively?
• How fast can we launch a serious business analytics initiative? What’s holding us back?

3. What's the payoff?

• What are our specific performance goals in the area where we choose to compete?
• How well do we measure them? How might better measurement and analysis of today’s performance reveal tomorrow’s opportunities?
• How well aligned are the organization, its management, and its stakeholders with these performance goals?
• What’s our highest ambition? What would it mean in terms of revenue, profit, and market share if we were really to change the basis of competition?

4. What information and technology do we need?

• Is the information we need at hand? Is the data that support our distinctive capability in one repository, with common definitions of key data elements?
• Is this data integrated enough not only to be accessible, but also to be manipulated with analytical tools?
• How completely and accurately does the information measure and represent our distinctive business capability and basis of competition? Is it up-to-date? What are the most glaring gaps and shortfalls?
• Do we have the technologies in place to support business analytics in this area? Or is technology fragmentation holding us back?

5. What kinds of people do we need?

• Do we have a critical mass of analytical professionals on staff? Are we prepared to hire them? Do we need to “rent” this talent in the short term to fill gaps?
• Who can manage analytical professionals? Who has the necessary experience, credibility, and “bridging” skills?
• Will we be ready to train employees to apply the analytical results and operate differently?
• Is the organization at large oriented toward analytical decision-making, or is it wedded to yesterday’s procedures and rules of thumb? How quickly can the organization come up to speed analytically?

6. What roles must senior executives play?

• Are we committed to competing on analytics, starting at the top of the organization? What are the CEO and executive team doing to demonstrate that commitment?
• Is the leader of the analytical function prepared to act upon the results of the analyses? Are the roles and decision rights of other stakeholders, including the CFO and CIO, clear – especially when their roles are novel or overlap?
• Do we have a project leader who can span the worlds of strategy, process performance, and analytics?

Reference: Business Analytics: Six Questions To Ask About Information And Competition (2008), Austin, TX: nGenera Corp.

The “Limits of Arbitrage” Agenda

by Denis Gromb and Dimitri Vayanos © VoxEU.org

Why do financial market anomalies arise and persist? This column summarises a new thread in financial economics – the "limits of arbitrage" literature – explaining how financial institutions sometimes lack the capital needed to arbitrage away anomalies. This new approach has far-reaching implications for our understanding of how financial markets work and how they should be regulated.

Each financial crisis reminds us that governments are vital to the functioning of financial markets – with the current crisis being a particularly painful reminder (see for example Boone and Johnson 2010, Dewatripont et al, 2009).

Standard models, however, are ill-suited to analysing public policy. These models were developed to study the properties of asset prices; they typically ignore financial institutions and the financial constraints to which they are subject. Institutions, jointly labelled “arbitrageurs” in the theory, are instead assumed to have unfettered access to all the capital they need.*

Frustratingly optimistic theory

For economists with a public policy interest, what one might call the “unconstrained arbitrage” hypothesis delivers a frustratingly optimistic message. Financial markets are in a socially efficient equilibrium; consequently, public intervention is at best redistributive and at worst inefficient. This result, a special case of the so-called fundamental welfare theorems, captures the idea that in a free market economy, prices adjust so that profit-maximising agents end up making socially efficient choices.

Recent developments in financial economics may offer a more useful framework for policy analysis. To understand how these developments came about, we must take a step back and understand what unconstrained arbitrage really means for asset prices, the empirical challenges this hypothesis has met with, and the new theories emerging to deal with those challenges.

No free lunch on Wall Street

The main implication of the “unconstrained arbitrage” hypothesis is that there should be no arbitrage opportunities in equilibrium or, in plain English, no free lunch on Wall Street. This cornerstone of both the modern theory of asset pricing and its industry applications has itself two important corollaries.

• First, assets with similar payoffs should trade at similar prices (law of one price).
• Second, asset prices should change only in response to news about fundamentals, and news being by definition unpredictable, asset returns should also be unpredictable (efficient market hypothesis).

The main impetus to reconsider standard models was provided by what financial economists have affectionately dubbed market anomalies."

• For a start, some pairs of assets with very similar payoffs consistently trade at substantially different prices, in apparent violation of the law of one price. Newly issued “on-the-run” government bonds can trade at significantly higher prices than older “off-the-run” government bonds with nearly identical payoffs.
• Other anomalies concern the predictability of asset returns such as the “momentum effect”, whereby an asset's recent price performance tends to persist in the short run.

In both cases, the standard theory predicts that arbitrageurs would spot these proverbial free lunches, trade on them, and eliminate them in the process. For instance, arbitrageurs would buy the off-the-run bond and short the on-the-run bond to exploit their relative mispricing, but doing so they would narrow the price gap so that by the time mere mortals wake up, the free lunch has come and gone and all but crumbs are left.

These empirical discoveries have prompted a very active debate among financial economists (as well as very active trading by hedge funds).

• Some try to reconcile the anomalies with more sophisticated versions of the standard theory that still retain the assumption of unconstrained arbitrage.
• Others reject the more fundamental assumption that traders are rational and instead explain the anomalies based on behavioural biases.
• Yet another group lies somewhere in between, believing that arbitrageurs are crucial for the workings of financial markets but thinking of them as having to do their job with one hand tied behind their backs.

The limits of arbitrage

In a recent paper (Gromb and Vayanos 2010) we review the achievements and promises of this third way, the “limits of arbitrage” literature. This research seeks to understand why perfect arbitrage does not always happen in practice, i.e. why anomalies arise and persist. Its focus is on the process of arbitrage, with an emphasis on financial institutions, the real-world incarnations of textbook arbitrageurs, and on the constraints they face.

The premise is that arbitrageurs face constraints in that they cannot always raise the capital they need even when they face good investment opportunities. As it turns out, this simple premise has far-reaching implications for finance, and financial economists are only beginning to understand their full range and scale.

Suppose for instance that some investors suddenly want to sell a large amount of a given asset. These investors may be individuals, day-traders, mutual funds, banks, it does not matter for our example, and neither does the reason why they so suddenly want to sell. In any event, this “supply shock” has the potential to cause a drop in the asset’s price, which would offer an attractive investment opportunity for arbitrageurs.

Without constraints, arbitrageurs as group would simply absorb that supply shock, i.e. buy the asset the investors want to sell. If they required additional capital to buy the asset, arbitrageurs would be able to find it. As a result, even a large shock would have only a limited price impact. But once we consider that arbitrageurs face financial constraints, the picture is totally different. Indeed, if arbitrageurs cannot raise additional capital easily, they may not be able to absorb the shock fully and selling pressure can have a substantial and lasting price impact. Overall, when arbitrageurs as a group are flush with money, financial markets’ behaviour should resemble that of the standard theory. But if and when their capital is low, strange things can happen.

This simple enough insight is proving very fruitful. Let’s consider two of the tastier pieces of fruit. Both come from an important remark. If arbitrageurs’ capital affects asset prices, the reverse is also true.

First, the new approach has helped explain how small shocks can have big effects, as tends to be the case in financial crises. Consider again our supply shock example. We have seen that arbitrageurs facing financial constraints may not be able to absorb this shock, allowing it to have a substantial price impact. Things may be even worse. Suppose that before the shock, the arbitrageurs hold substantial amounts of that asset. A shock might cause the asset’s price to drop, implying a capital loss for the arbitrageurs. Not only may arbitrageurs not be able to absorb the shock fully, they may even be forced to liquidate assets themselves, pushing prices further down. In that case, arbitrageurs’ effect on asset prices is neither stabilising nor neutral, it is destabilising.

Second, the limits of arbitrage can rationalise episodes of contagion across asset markets. Here’s how it works. Following a supply shock in one market, the capital of arbitrageurs may be depleted. But since arbitrageurs draw from the same pool of capital to absorb shocks in different markets, a drop in their capital may force them to liquidate positions in other markets, affecting asset prices in those markets. Overall, a shock in one market affects other markets.

Inefficient markets

Research on the limits of arbitrage might very well reshape our understanding of financial markets. The next and arguably most important question however is whether it can provide a useful framework for public policy. Despite its relevance, the welfare analysis of asset markets with limited arbitrage is still in its infancy. But we believe it has great potential.

This research emphasises the role of financial institutions in the functioning of asset markets. Accordingly, these institutions’ financial health affects the functioning of markets. As we have seen, the reverse is also true. Their financial health is itself affected by asset prices through the capital gains and losses arbitrageurs realise. Now the question is whether arbitrageurs take financial positions putting their capital at risk in a way that is desirable for them and society as a whole. In an earlier paper laying out a model of financially constrained arbitrage (Gromb and Vayanos, 2002), we explain why the answer is “No.” In technical jargon, the welfare theorems do not hold.

Chain externalities

Follow the logic. Supply shocks have the potential to cause movements in asset prices, which constitute profit opportunities for arbitrageurs. Each arbitrageur however needs capital to be able to grab those tasty snacks. That’s fine; he might simply set capital aside in good times to be used when the opportunity arises and cash is king. In fact, a number of prominent investors follow such a strategy of keeping dry powder ready for when the goings get tough. Of course, setting capital aside means foregoing some risky but profitable opportunities available to arbitrageurs. Yet each arbitrageur can compare the benefit of investing in those opportunities to the cost of being short of capital in case of a big shock, and then decide for himself on the right amount based on this cost-benefit analysis. So far, still no inefficiency. However, there is something each arbitrageur does not fully take into account when deciding how much dry powder to keep and how much capital to put at risk. Indeed the cost of being short of capital in case of a shock is less than the implied social cost. When an arbitrageur is short of capital, not only is he unable to exploit the price movement caused by the shock, but as we have seen, his inability to do so amplifies the price effect of the shock. In turn lower prices cause other arbitrageurs to incur bigger capital losses, forcing them to liquidate assets, further depressing prices. This chain reaction has the effect of depriving arbitrageurs of capital right at the time when it would be most socially useful.

Policy

While in the standard model the invisible hand and its competitive prices elves gently guide towards taking socially optimal decisions, here they don’t. Instead, they drive arbitrageurs to put too much of their capital at risk. Since the price system cannot do its job of guiding agents, it can be good if someone else, a regulator perhaps, can provide that guidance. Regulation incentivising or even forcing arbitrageurs to take less risk could make everyone better off, arbitrageurs included.

How might this be best achieved? Risk-based capital requirements? Taxes and subsidies? A lender of last resort policy? Asset purchase programs? This is pretty much where this research agenda is at. The answers to these fascinating questions are still pending and hotly debated by academics and practitioners (see, for example, Sarkar and Shrader 2010). Hopefully, they’ll be ready by the time the next crisis hits.

References:

Boone, Peter and Simon Johnson (2010), “The Doomsday Cycle,” VoxEU.org, 22 February.

Dewatripont, Mathias, Xavier Freixas, and Richard Portes (2009), “Macroeconomic Stability and Financial Regulation: Key Issues for the G20,” VoxEU.org, 2 March.

Gromb, Denis, and Dimitri Vayanos (2002), “Equilibrium and Welfare in Markets with Constrained Arbitrageurs,” Journal of Financial Economics.

Gromb, Denis, and Dimitri Vayanos (2010), “The Limits of Arbitrage: The State of the Theory,” Annual Review of Financial Economics, forthcoming.

Sarkar, Asani, and Jeffrey Shrader (2010), “Financial Amplification Mechanisms and the Federal Reserve’s Supply of Liquidity during the Crisis,” Federal Reserve Bank of New York Staff Reports, no. 431.

*Textbook arbitrageurs represent professional arbitrageurs such as hedge funds and proprietary trading desks, but also and more generally financial intermediaries such as dealers, banks or mutual funds.

Reproduced with permission of VoxEU.org