ECB Sterilization Capacity: Unlimited

When the ECB purchases bonds, it creates new reserves, increasing its balance sheet, and then sterilizes the reserves by auctioning fixed-term deposits. There is no limit to that process.
People pretending otherwise are relying on ancient macroeconomics manuals where the size of the balance sheet was constrained (i.e not expanded) and sterilization was limited by the amount of marketable assets held.

CDS on the EFSF

Made a few comments on that post: Pricing CDS on the EFSF

I should add that in case of multiple joint defaults, the remaining guarantors can discharge their obligation by simply buying back EFSF bonds instead of paying par.

MMT Is Bullshit

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of non-government net financial assets.

So, “recipient’s deposit account has no corresponding liability in the banking system”
Well, IT IS a liability.

In terms of its real effects QE2 could have actually been more of a drag on the economy than a form of stimulus. We know for a fact that the Federal Reserve turned over $73B in profits to the US Treasury in 2010 alone. That is largely interest income that is being taken away from the private sector as a result of their massive balance sheet expansion. Remember, this is interest income that the banks could have been earning. Instead, they are receiving 0.25% paper in exchange for their much higher yielding securities. QE does not add net financial assets to the private sector so the net financial drag appears to have been quite substantial.

So, this “interest income that is being taken away from the private sector” where does that it go? Well, government spending does end in somebody’s pocket.

ISDA Standard CSA

ISDA outlines key provisions to the Standard Credit Support Annex (SCSA) proposal as part of its continuing efforts to increase efficiency and improve standardization in the over-the-counter (OTC) derivatives markets.
The SCSA proposal addresses three primary objectives.
The SCSA seeks to standardize market practices by removing embedded optionality in the existing CSA, promote the adoption of overnight index swap (OIS) discounting for derivatives, and align the mechanics and economics of collateralization between the bilateral and cleared OTC derivative markets.
In addition, the SCSA seeks to create a homogeneous valuation framework, reducing current barriers to novation and valuation disputes.

ISDA Leads Industry Effort to Standardize the Credit Support Annex

Slide presentation

Explosive Volatility: A Model of Financial Contagion

Paper by Nicholas G. Polson, James G. Scott

This paper proposes a model of financial contagion that accounts for explosive, mutually exciting shocks to market volatility. We fit the model using country-level data during the European sovereign debt crisis, which has its roots in the period 2008–2010, and was continuing to affect global markets as of October, 2011. Our analysis shows that existing volatility models are unable to explain two key stylized features of global markets during presumptive contagion periods: shocks to aggregate market volatility can be sudden and explosive, and they are associated with specific directional biases in the cross-section of country-level returns. Our model repairs this deficit by assuming that the random shocks to volatility are heavy-tailed and correlated cross-sectionally, both with each other and with returns.
We find evidence for significant contagion effects during the major EU crisis periods of May 2010 and August 2011, where contagion is defined as excess correlation in the residuals from a factor model incorporating global and regional market risk factors. Some of this excess correlation can be explained by quantifying the impact of shocks to aggregate volatility in the cross-section of expected returns—but only, it turns out, if one is extremely careful in accounting for the explosive nature of these shocks. We show that global markets have time-varying cross-sectional sensitivities to these shocks, and that high sensitivities strongly predict periods of financial crisis. Moreover, the pattern of temporal changes in correlation structure between volatility and returns is readily interpretable in terms of the major events of the periods in question.

Withdrawal and Expulsion from the EU and EMU

ECB paper by Phoebus Athanassiou (Legal Counsel, European Central Bank)

Implications of a Member State’s withdrawal or expulsion for its euro area participation and its use of the euro [starts page 39]

Membership of the euro area presupposes membership of the EU and participation in ERMII for at least two years, followed by the candidate Member State’s adoption of the euro after a unanimous decision of the Council. In the unlikely event that a Member State withdraws
voluntarily or is expelled from the EU, its NCB’s membership of the European System of Central Banks (ESCB) and euro area participation would be terminated, with the departing Member State having to restore its old currency or adopt a new one.

Restoring a Member State’s old currency or adopting a new one would inevitably involve considerable risks and difficulties and entail substantial legal complications, including with regard to the validity and enforceability of outstanding re-denominated contracts between debtors in the withdrawing Member State and their creditors. Successfully resolving the issues arising would necessitate very close cooperation between the departing and the remaining Member States . While it may sound attractive, the idea of using the agreement with the Council provided for in the Lisbon Treaty exit clause for negotiating a departing Member State’s continued participation in EMU (even temporarily) after that Member State has withdrawn from the EU is questionable, not least from a public policy perspective.

Accepting this would postulate the withdrawing Member State’s right to ‘pick and choose’ which of its treaty obligations it will continue to be bound by (in this case, its EMU obligations) and which it will be released from after its withdrawal from the EU. This would effectively encourage an à la carte approach to EU participation which, while conceptually not that far removed from the opt-out clauses that some Member States have negotiated from the EU Treaty or, more recently, from the Lisbon Treaty, would pose a qualitatively different and arguably intolerable challenge to the EU’s integrity and sustainability. Moreover, even if it were accepted that it is possible for a voluntarily withdrawing Member State to negotiate its stay in EMU, it would be difficult to envisage any such agreement allowing a departing Member State that is expelled by its EU partners to stay in EMU.

The potential for unequal treatment, depending on the manner of a Member State’s departure (in particular whether the departing Member State withdraws voluntarily or is expelled) favours the conclusion that withdrawal from the EU without a parallel, negotiated withdrawal from EMU would be inconceivable. The fact that the requirements for joining the EU (the Copenhagen criteria) differ from those applicable to euro area accession (the Maastricht convergence criteria) is of no relevance. EMU is a sub-set of the EU, which is why the Statute of the European System of Central Banks and of the European Central Bank – lying at the heart of the ESCB and the Eurosystem – is annexed as a Protocol to the EC Treaty. For this reason, a Member State’s exit from the EU would automatically posit its exit from EMU.

Whilst a Member State’s exit from the EU would, therefore, entail its exit from the euro area, this does not necessarily mean that the euro could no longer circulate in its territory. Indeed, a distinction should be made between a Member State’s euro area participation, in an institutional sense, and the circulation of the euro in its territory. Institutionally, a former Member State’s NCB could no longer form part of the euro area (i.e. it could not participate in the governance structure and decision-making bodies of the ESCB), at least not without an amendment to the EC Treaty and the Statute of the ESCB. Whether or not a former Member State could continue using the euro is a different, more controversial question, harking back to the ‘euroisation’ debate (especially if the Member State concerned proposes to use only the euro, which it would obtain from the market).

An autopsy of the US Financial System: Accident, Suicide, or Negligent Homicide

Paper by Ross Levine, Brown University

The evidence is inconsistent with the view that the collapse of the financial system was caused only by the popping of the housing bubble (“accident”) and the herding behavior of financiers rushing to create and market increasingly complex and questionable financial products (“suicide”). Rather, the evidence indicates that senior policymakers repeatedly designed, implemented, and maintained policies that destabilized the global financial system in the decade before the crisis. Moreover, although the major regulatory agencies were aware of the growing fragility of the financial system due to their policies, they chose not to modify those policies, suggesting that “negligent homicide” contributed to the financial system’s collapse.

Marx vs. Weber: Does Religion Affect Politics and the Economy?

ECB paper by Christoph Basten, Frank Betz

We investigate the effect of Reformed Protestantism, relative to Catholicism, on preferences for leisure and for redistribution and intervention in the economy. With a Fuzzy Spatial Regression Discontinuity Design, we exploit a historical quasiexperiment in Western Switzerland, where in the 16th century a so far homogeneous region was split and one part assigned to convert to Protestantism. We find that Reformed Protestantism reduces the fraction of citizens voting for more leisure by 13 percentage points, and that voting for more redistribution and government intervention by respectively 3 and 11 percentage points. These preferences are found to translate into greater income inequality, but we find no robust effect on average income.

Fear, Social Projection, and Financial Decision Making

Paper by Eduardo Andrade and Chan Jean Lee

The number of individual investors who trade stocks online has significantly increased in recent years. Surprisingly, consumer researchers have paid little attention to how emotions influence individual investors’ stocktrading decisions. In a series of three experiments, the authors investigate the impact of incidental fear on the decision to sell in a stock market simulation. The results show that fearful (vs. control) participants sell their stock earlier (Experiments 1–3). This effect, however, is contingent on particular features of the market. Fear leads to early sell-off when partipant believe the value of the stock is peer generated but not when they believe the value of the stock is computer generated (Experiment 2). Early sell-off as a result of incidental fear also occurs when participants believe their risk attitude is common in the market but not when they believe their risk attitude is unique (Experiment 3). Social projection—that is, people’s tendency to rely on their current state of mind to estimate other people’s actions—explains the phenomenon.

Study sheds eerie light on fright and financial decision making [Physorg]

EFSF: FAQ [ Updated ]

Option 1 – Credit enhancement

E11 – What will be the scope of the protection under option 1?

The partial protection certificate will cover a portion of the principal value of the bond. The precise amount will depend on market conditions and the country circumstances. In the public discussion, often a value of 20% has been mentioned, which however will have to be confirmed.

E12 – How will the event of default be defined?

The event of default could be defined differently from the one set by the International Swaps and Derivatives Association (ISDA). A credit event (default) could be defined as the Member State failing to pay either a scheduled interest or principal payment.

E13 – How and when will the certificates pay out?

Following a default event, the incurred loss per bond will be determined. The certificate will entitle the holder to claim their entitlement against this loss in EFSF bonds.

E14 – Will the certificate cover both principal and interest of the underlying bond?

The intention is that it will cover part of the principal value of the underlying bond.

E15 – Will the certificate cover more than one country?


E16 – What will be the cost of the certificate?

The investor will be receiving a lower coupon from the Member State than current market yields reflecting the intrinsic value of the certificate on day 1.

E17 – Will there be a cap for intervention in secondary markets?

There is no ex-ante cap, but the amount of interventions will ultimately depend on the degree of leverage and hence on the enhanced capacity of the EFSF.

E18 – Why should an investor participate in this scheme rather than buying a newly issued bond and simultaneously buying protection in the CDS market?

This is for investors to judge. The main difference is that the partial protection certificate will be backed by EFSF collateral and therefore the investor will have counterparty risk to the EFSF (AAA) rather than the provider of a CDS.

E19 – Why should an investor participate in the scheme rather than buy a plain vanilla bond issued by the Member State?

Whilst existing member state market yields are higher than the coupon under the scheme, investors holding the partial protection certificate will enjoy a degree of credit protection
provided by EFSF bond collateral with a AAA rating.

E20 – Who are the likely users of the scheme?

Institutional investors willing to take European sovereign risk with credit enhancement.

E21 – Doesn’t this scheme segment the sovereign bond market?

The bonds issued by Member States under this scheme will be identical in every respect to existing bonds issued by that country. This is the reason why the partial protection certificate could be detachable and separately traded.

E22 – How does EFSF expect the newly-issued bonds to trade in relation to existing

The bonds will be identical to existing bonds and are expected to trade in line with them. However the actions of the EFSF in support of sovereign bonds for that country is intended to have a positive impact on investors’ perception of all sovereign bonds issued by that country.

E23 – How will EFSF ensure a liquid market for the certificates?

This will be a relevant consideration for the EFSF in deciding how to activate the scheme in relation to a particular country, and EFSF will engage closely with relevant market

E24 – What will be the effect of this scheme on the CDS market for the Member

That is a matter for investors, who will have different preferences; the two instruments are not identical. The partial protection instrument offers superior protection as a risk management tool to a CDS in a certain respect, as explained above.

E25 – How will negative pledge clauses relating to existing Member State obligations
affect the scheme?

This will be determined through due diligence in relation to the circumstances of any specific country before the EFSF decides to implement the scheme in relation to that country.

E26 – Will this scheme increase the headline debt figure of the Member State?

Any statistical effect of this sort will be determined in discussion with Eurostat.

E27 – How will the scheme reduce the cost of issuance for the member state?

EFSF is providing loss protection for investors in newly-issued bonds and thus the risk profile of these bonds for investors is reduced; this will be reflected in pricing.

E28 – Has EFSF had direct conversations with investors and what were their

Initial conversations have been held with a number of investors; these have informed the design of the scheme. More detailed soundings will now take place.

Complete FAQ [ EFSF ]

The Atlas of Economic Complexity

Researchers find a country’s wealth correlates with its collective knowledge



Book: The Atlas of Economic Complexity [ PDF free ]


New technology pinpoints anomalies in complex financial data [Pacific Northwest National Laboratory] Identifying atypical information in financial data early could help identify problematic financial trends such as the systemic risk that recently put the U.S. and global financial systems in … Continue reading

More Papers

Web search queries can predict stock market volumes



Positive words carry less information than negative words



Memory Effects in Stock Price Dynamics: Evidences of Technical Trading

Paper by Federico Garzarelli, Matthieu Cristelli, Andrea Zaccaria, Luciano Pietronero

Technical trading represents a class of investment strategies for Financial Markets based on the analysis of trends and recurrent patterns of price time series. According standard economical theories these strategies should not be used because they cannot be profitable. On the contrary it is well-known that technical traders exist and operate on different time scales. In this paper we investigate if technical trading produces detectable signals in price time series and if some kind of memory effect is introduced in the price dynamics. In particular we focus on a specific figure called supports and resistances. We first develop a criterion to detect the potential values of supports and resistances. As a second step, we show that memory effects in the price dynamics are associated to these selected values. In fact we show that prices more likely re-bounce than cross these values. Such an effect is a quantitative evidence of the so-called self-fulfilling prophecy that is the self-reinforcement of agents’ belief and sentiment about future stock prices’ behavior.

The Atlas of Economic Complexity

Researchers find a country’s wealth correlates with its collective knowledge



Book: The Atlas of Economic Complexity [ PDF free ]

Argentina: Inflation and Lies

Paper by Alberto Cavallo Since the crisis and devaluation of 2002, Argentina’s in?ation has gradually made a comeback. In January 2007 the government seized control of the National Statistics and Census Institute (INDEC) and started publishing price statistics that have … Continue reading

Wolfson Economics Prize

#bbpBox_126580381850939393 a { text-decoration:none; color:#0084B4; }#bbpBox_126580381850939393 a:hover { text-decoration:underline; } UK cash prize offered for euro zone exit plan October 19, 2011 9:48 am via TweetDeckReplyRetweetFavorite @Alea_ alea Wolfson Economics Prize