More deep thoughts about macro models

Jérémie Cohen-Setton at Bruegel does a great job, as usual, rounding up recent blog posts on a specific topic. This time: a critique of modern macro. Can the models built during the Great Moderation explain what happened after the Great Recession?

I would say that "raising the profile" of the financial sector within macro models helps--but I don't know whether a Copernican revolution is necessary. But, ultimately, we will always (literally, always) have to live with model uncertainty. Noah Smith makes this point well.

Global financial stability: the IMF report

Financial stability has been a bubbling topic since 2008--although it never really stopped simmering since the emerging market crises of the 1990s. Over the past year or so, a dominant view seems to be forming that financial instability risks are rising, particularly among some emerging-market countries.

Here's a list of great articles or papers, and one oral presentation, on the topics of financial instability, financial crises, etc. I have perused recently:

• Emerging market macroeconomic resilience to external shocks: today versus pre-global crisis (pdf) by Liliana Rojas-Suárez at the Center for Global Development.
• The mythic quest for early warnings, by Cecchetti and Schoenholtz.
• The coming emerging-market debt squeeze, by Andrés Velasco at Project Syndicate.
• Negative rates and financial intermediation, by Jérémie Cohen-Setton at Bruegel.
• Do eerie parallels presage new crisis? by Satyajit Das at the Financial Times.
• The glaringly obvious guide to the next crash, by James Mackintosh at the Financial Times.
• Getting up to speed on the financial crisis: A one-weekend-reader's guide (pdf), by Gary Gorton and Andrew Metrick.
• New evidence on the impact of financial crises in advanced countries (pdf), by Christina Romer and David Romer.
• Private credit, public debt, and financial crises (30 min lecture), by Òscar Jordà.
• Articles by Jesse Colombo, on Forbes, on why the Philippines, Thailand, Malaysia, and Singapore are heading for trouble. 
• Financial openness and currency crises, by Jon Frost and Ayako Saiki, guest post at Econbrowser. 

Chapter 1 of the IMF's Global Financial Stability Report (pdf), published this week, warns of the main risks to global financial stability. Here's a summary of the report:

1. Financial stability risks have increased since October. Lower growth prospects and disinflation have prompted central banks to respond by loosening policy. The BoJ and the ECB are the most notorious examples, but other central banks have relaxed their monetary policy stances as well.

2. Emerging market financial stability risks have increased. Commodity price declines have hurt commodity exporters, while the corporate sector has increased its foreign currency indebtedness. Lower energy prices have impacted negatively firms in the energy sector. 

3. The fall in nominal yields, and flattening of the yield curve, are a threat to the life insurance and pension fund sectors, especially in Europe.

4. Monetary policy divergence has lead to a sharp increase in volatility in foreign exchange markets amid the appreciation of the U.S. dollar. Term premia are narrow in all three main currencies (dollar, euro, and yen). Asset valuations remain elevated, in part because of persistently loose monetary policy. Market volatility in general has increased.

5. Quantitative easing can boost inflation and growth, but it also encourages greater financial risk taking, so monitoring and addressing financial excesses is necessary. Additional policy measures are necessary to enhance the effectiveness of monetary accommodation.

The report also has special boxes for two sub topics:

• The oil price fallout, explaining the channels through which the abrupt fall of oil prices could spawn financial vulnerabilities.
• Russia's financial risks and potential spillovers.

Here are a few charts from the report that caught my attention. Having a good legal system helps a country de-leverage. According to the chart below, an index of the strength of the legal system explains 45% of the cross-sectional dispersion of de-leveraging:

An increasing number of short- and long-term European government bonds have a negative yield:

QE in the eurozone and Japan could lead to significant portfolio outflows. Eurozone investors might allocate up to €1.3 trillion abroad by the end of 2015, a good chunk of which would go to the U.S. Insurance companies and pension funds in Japan could invest as much as $559 billion, or 12.8% of GDP, in foreign assets by the end of 2017 (that's if announced policies are fully implemented and work to their fullest extent across the three reform arrows): 

Non-performing loans and write-offs are frighteningly high in the eurozone and Japan:

European life insurers are in the unsustainable business of writing long-term policies without assets of a correspondingly long duration, which has resulted in negative duration gaps. Moreover, many policies contain high return guarantees, which are unsustainable in a low-interest-rate environment. Insurers in Sweden and Germany have the largest mismatches: 

Despite the recent round of monetary policy easing in emerging markets, real rates are expected to rise in 2015 in almost all of them:

Debt of the non-financial (private and government) sector of emerging markets has increased dramatically since 2007:

A significant share of debt is owed by firms with poor interest-coverage ratios:

Global activity: mixed nowcasts

Fulcrum's nowcasting model shows that advanced economies have decelerated so far in 2015:

The slowdown is particularly persistent in the U.S., which is now estimated to be growing at 2% a year, half the pace of last fall:

China is growing at a fairly steady pace, and the eurozone's economy keeps picking up:

According to the Institute of International Finance's EM Coincident Indicator "EM GDP may have grown in 2015Q1 at its weakest pace since early 2009", or 1.8% q/q saar:

That's at odds, however, with the J.P. Morgan global composite output index, which picked up slightly from an average of 53.0 in Q4 (53.0) to 53.9 in Q1:

And, despite a plunge of the J.P. Morgan  U.S. composite in earlier months, output has rebounded of late:

And the HSBC emerging markets composite index looks fairly stable, not falling:

Guest post: Are Australian investors (relatively) conservative?

Naomi Fink, CEO and founder of Europacifica Consulting, is my guest today, writing about the risk preferences of Australian investors.

In one of the preliminary documents leading to Australia’s Financial System Inquiry, authors speculated that the abundance of overseas financing for Australia might owe to a gap in risk preferences between domestic and foreign investors (no supporting evidence or parameter calibration was cited).

Anecdotally, yet consistent with this viewpoint, many players within the domestic financial sector tout about the supposed conservatism of Australian domestic investors.  But is there empirical evidence of such conservatism?

Firstly, following the argument made in passing in the preliminary FSI documents, if divergent risk preferences were the best explanation for Australia’s chronic current account deficits, they would explain Australia’s investment income deficit (the largest component of Australia’s external deficit), given the sensitivity of investment rather than trade to relative risk preferences.

The argument implies, first, that foreign investors should be categorically more risk-tolerant than Australians, who pay higher premiums to compensate for the higher risk of capital they export than what they receive on their lower-risk investments overseas.

The second implication of the argument is less obvious.  Risk preferences in financial economic models are typically parametric rather than variable. Extending this logic, Australia’s investment income deficit is the result of more consistently conservative attitudes among domestic investors in comparison to consistently risk-tolerant overseas counterparts.  This may seem to be splitting hairs, but the distinction is non-trivial.

Risk premiums may wax and wane alongside risk perception, while risk preferences among rational investors are typically more consistent over time.  But if this were so, we would expect to see behavioral evidence of consistently greater risk-aversion among Australian investors than their overseas counterparts.

We took it upon ourselves to perform our own stylised version of the missing calibration; a comparison of risk preferences among OECD countries (using equity market participation, per Vissing-Jorgenson (1997), Guiso (2002), and Guiso et al. (2008)).

This basic examination of parametric measures of relative risk tolerance undermines the hypothesis that Australian investors are relatively risk-averse.

Our results, shown in the chart below, not only argue against the notion that Australia is more risk-averse than the rest of the world: they show that Australia is one of the most risk-loving players in the OECD.  In this light, it is highly doubtful that relative risk preferences somehow structurally rationalize Australia’s income deficit.

Note: Arguments that Australia pays a higher premium on its debt because Australians are more risk-averse than the rest of the world fail to hold up to our calibration.

Source: Europacifica, OECD