BUBBLES AND MACRO RISK

Frederic Mishkin says not all bubbles are a threat to the economy (link):

"Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy..."

PENSION REFORM AND MACROECONOMIC STABILITY

The issue of pension reform is definitely the most challenging macroeconomic issue in the time to come. Faced with unfavorable demographic situation, economic policymakers in Western countries will need to reconsider the structure of the pension system to ensure the long-term sustainability of pension systems and overall macroeconomic stability as well. Negative demographic trends, namely a decreasing labor supply relative to increasing retirement rates as post-WW2 baby-boom generations retire and the burden of the welfare state is beared by the existing labor supply thru higher tax burden unless the reforms are launched.

Jose Pinera predicted (link) that Europe's aging population and the unsustainability of pension systems in the Euroarea could distort the functioning of optimum currency area and, consequently, launch a series of instability issue in the euroarea due to the inability of fiscal policies to cope with the exponentially growing net financial liabilities to the retirement system. Ageing population is, of course, more pronounce in the euroarea and Japan compared to the United States or Canada. In G7, assuming ceteris paribus, dependency ratio is expected to move from 40 percent to 70 percent by 2050.

The evidence from the OECD predicts that by 2050, Spain and Italy will face the highest dependency ratios. In Sweden, where private retirement accounts have been introduced (link) as a long-range supplementary to PAYG system back in 2000 (link), the trend of the ratio of population aged 65 and over is expected to reverse between 2030 and 2040. The United States is the only advanced country where the share of population aged 65 and over is not expected exceed 40 percent of the overall population (link).

Recently, Martin Neil Baily and Jacob Funk Kirkegaard of the Peterson Institute wrote a book entitled US Pension Reform: Lessons from Other Countries (link). The authors examined the prospects for the reform of the pension system in the United States considering the evidence from abroad. They showed that southern (Spain, Italy, Greece, Portugal) and continental (France, Germany, Belgium, Austria, Hungary, Slovenia) European countries are in the dead-end scenario of weak total assets of the pension system, unsound government finances. Although Austria, Spain and Belgium had a surplus structural fiscal balance in 2006, these countries are still unfamous for high corporate and personal income tax burden which has, by all empirical proportions, a negative overall effect on labor supply as working time is substituted for leisure activities, while as those of you who studied introductory micro and macro, productivity is the key to higher standards of living.

There is a three-step approach that European welfare states must face sooner or later if these countries want to avoid a continuous macroeconomic crisis whose effect is similar to oil supply shocks in 1970s. First, pension systems should be privatized by the introduction of private retirement accounts and PAYG net financial obligations should diminish gradually either in the framework of fiscal policy rule or in terms of partial lump-sum in the intragenerational transfer. Second, the transition to private retirement accounts must ensure the combination of risk-management approach to portfolio investment and returns managed by private pension funds. Sound and smart regulation should not be avoided such as the avoidance of investment into toxic assets backed by subprime mortgages where a decreasing interest rate has virtually inflated assets prices and propelled a the burst of the bubble that spurred the financial crisis in 2008/2009.

However, lessons from financial crisis and financial innovation will probably peer the question whether pension funds shall benefit from investing in asset-backed securities. Traditionally, pension funds diverse the portfolio structure by hedging or diversification into a stable and predictable rates of return with low beta coefficient on most of securities as pension fund managers aim to reduce the variability of return rates as risk fluctuates except for in optional accounts. And third, European countries should immediately deregulate its rigid and inflexible labor markets and also strongly decrease marginal and average tax rate on personal and corporate income and should nevertheless immediately raise the retirement age in the effort to stimulate labor supply and avoid early retirement. The combination of high tax burden, early retirement age and inflexible labor markets is a vicious circle where stagnation, ageing time bomb and macroeconomic crisis are the main consequence of delaying pension reforms into the future while such reforms never really happen.

AFTER YEARS OF TREMENDOUS GROWTH, THE ECONOMY OF ICELAND FEELS THE HEAT

Financial Times just recently posted an article about the macroeconomic and financial prospects of Iceland regarding recent turmoil in financial markets.

Throughout 1990s, Iceland's economy recovered signficantly subject to economic and structural reforms. As a result, fishing, which still remain the dominant source of export revenue decline from 16 percent in 1980 to 6 percent last year, being replaced by finance, insurance and real estate. Moreover, Iceland's three largest banks, Glintir, Landsbanki in Kaupthing have asset capitalization of more than 110 billion EUR, which is more than eight times Iceland's GDP.

So how have the prime movements in credit markets affected risks associated with financial turbulence? A report from F. Mishkin and T. Herbertsson has shown that Iceland's economy is stronger than ever, concluding that fears of rough landing and possible recession were overblown. In a broader sense, Iceland's banking sector was not intensively exposed to credit market turmoil as banks increased their operating capacity by switching to retail deposits as a pattern of funding.

In addition, total assets of Icelandic banks remain solid and there has been almost no sign of a liquidity loss, default loans, exposure to subprime mess and credit blowing. But, loan to deposit ratio is still around 300 percent, reflecting the dependence on gross markets. The question is how the sovereign risk may be managed. Explosive growth of financial sector has certainly benefited Iceland's economy but the problem is the long-term sustainability of risk management due to immediate or sudden fluctuations in business cycle and exchange rate. In fact, krona, Iceland's currency, has been one of the weakest performers recently. Agreeably, the information asymmetry plays an important role in this case. It is important how banks perceive macroeconomic risk and respond to imbalances. As a result, market premium shows how the investors absorbed and perceived the information about Iceland's economy accountably.

NORWAY'S OIL SAVINGS AND PETROLEUM FUND

More than a year ago, I noticed an article written by Stefan Karlsson entitled "Norway's National Day" where the author explain how Norway's oil-savings policy and also the recycling of savings accumulated from Norway's oil exports redirected into oil fund which invests into foreign securities and creates huge trade and current account surpluses. In fact, Norway is the third largest exporter of oil in the world after Russia and Saudi Arabia.

Using PPP measure of the GDP, Norway is the 6th wealthiest country in the world, having a per capita GDP at $46,300 USD, surpassing Ireland and the United States (link). High GDP per capita in terms of purchasing power parity is the result of gigantic increases in the GDP in recent decades due to high oil prices and oil exports which benefited the Norwegian economy. It would be a mistake to think that Norway's economic policy reflects its gross domestic product. Public ownership remains high (link). Welfare policies tend to contain a degree of inefficiency and fiscal sustainability (link) is risky in a long term perspective as the petroleum and pension fund are set to decline in its size subject to strong dependency and ageing population pressures (link).

ROMANIA INTRODUCES PRIVATE RETIREMENT ACCOUNTS (PRA's)

Romania has recently joined a growing list of nations that have switched from tax-funded state budget retirement system towards private pension investment funds (link).

In a new system, those aged under 35, must opt one of 14 competing pension funds, redirecting 2 percent of individual income from state budget to selected pension fund. The rate of contribution will gradually increase to 6 percent by 2015 and social security contribution rate is about to diminish effectively.

Romania is now officially joined member of the EU, facing a significant transformation towards a modern competitive economy. As a matter of fact, Romania faces a significant anti-correlation between labor supply and the number of retired individuals.

In case of state budget funding of retirement remained in effect, this could seriously affect and hamper the long-term stability of public finance and would boost tax rates on labor supply, saving and investment upward.

According to the data, Romania also faces a significant outflow of skilled labor into advanced economies within the EU, increasing the need to restructure the system of social security and pension funding.


Particular disadvantages of state-run budget pension fund is that, in the long run, it creates a significant degree of dependency, thus increasing the risk of macroeconomic crisis such as the outburst of public debt, growing budget deficits and the brisk of financial crisis which could, in turn, reverse into rachitic output rates and increased inflation pressures.

In addition, budget-funded pension system plagues inadequte methods and poor management track, unable to respond to intense demographic pressure, i.e. the shrinking labor supply and a growing number of retired individuals.

The report notes that by 2050, Romania will have 145 pensioners on 100 employees. In fact, it is admirable that a country such as Romania chose to opt a private pension system based on income percentage contribution to private pension funds, since accumulated savings are, by empirical means, the soundest guarantee of pursuing a lifetime living standard once when person is retired.

DOING BUSINESS: REVIEW AND PERSPECTIVE

The 2008 Doing Business project solidly provided a valuable tool in ranking the economies with respect to the ease of doing business. The quality of the business environment is, by any means, one of the essential supporting components of growth and value creation. Put simply, the greater the flexibility of the business environment and the ease of doing business, the greater the opportunities for the firm to target markets and growth while the foremost advantage of a dynamic business environment is the minimization of external risk, notably macroeconomic risk and the risk emerged from external vulnerabilities such as the failure of the public administration to provide sound entrepreneurial framework and business conditions. In spite of vital importance of dynamic entrepreneurial framework, small-scale economies are, by empirical investigation, affected by the extent of quality of the business environment far more than the economies of large scale according to the share in global economy they possess. That’s why; the first-class quality of the business environment is essential to long-term creation of venture capital and jobs as well as to output growth.

First, let’s take a look at the microeconomic aspect of rating the quality of business environment. Suppose there is a consulting firm with a certain amount of investment from venture-capital fund with an idea to target and invest in emerging markets whether by direct market entry or by indirect market access, i.e. through intermediaries. Firm’s executive board mutually decides to hire local human capital; local labor to reduce the potential risk of firm’s perception of asymmetric information about the local business environment in conducting consulting services to local firms or branches of global firms. Assume that the decision processing is as in usual firm’s entry. The barriers to doing business, in turn, crucially impact firm’s decision for investment location accountably regarding the size and attractiveness of market niches. Suppose the firm is decided to target emerging markets in Central and Eastern Europe and in broader Asian market. Consequently, the firm obtains all available data and information about the particular business environment, varying which one to choose. If a firm jointly varied among Czech Republic, Hungary and Slovenia as a headquarter base, how would the quality of the particular business environment affect firm’s decision where to invest. Suppose each business environment carries-in some strengths and weaknesses. For example, Czech Republic offers sufficient transportation links to the rest of Eastern Europe while Hungary offers a sound and deregulated corporate conditions such as low corporate tax burden and dynamically competitive financial sector (access to attractive financial, capital and insurance services) while Slovenia offers sound access to potential booming markets in South-Eastern Europe. In Asia, the firm varies between sophisticated and growing markets, say between China, India and Vietnam and Singapore and Hong Kong on the other side. Depending on the preferences included in firm’s panel, where would the firm decide to invest in to setup a base for targeting specific markets?

Of course, it is impossible to predict all circumstances of the firm’s decision since information is distributed asymmetrically. But let’s predict the possible scenario with respect to the quality of business environment, assuming that firm’s main decisive objective is to decide for the location with the easiest and most business-friendly environment with least administrative and regulatory burden given the impact of external cost pressures affecting firm’s output and organic growth performance.

Depending on the impact of firm’s strategic decisions regarding the performance of output and supply, the firm would, by rational means, choose the environment with the least regulatory complexity and administrative burden such as the quickness of starting a business, time costs of getting required licenses, the flexibility of labor market, the security of property rights, access to credit information, transparency of transactions, self-dealing liability, shareholders’ suing ability for misconduct and hence, tax compliance and time cost of paying taxes, the costs associated with international trade, contract enforcement, and the legal protection of the deprived party in exchange in case of payment dispute or payment delay and the extent of procedural backlash in case of closing the business.

The quality of the above-listed factors crucially determines the overall attractiveness of a particular business environment as an investment location. Looking globally, Singapore, New Zealand and the United States were ranked among top 25 on most areas except for in the area of the difficulty of paying taxes in case of the U.S. Emerging market countries scored variably. Russia is ranked 106^th, India 120^th, China 83^rd and Brazil 122^nd. From investment decision aspect, high economic growth in BRIC despite the low quality of the business environment is driven by strong investment boosted by remaining influential factors such as low proportion of labor cost attached to manufacturing and the convergence potentials of the GDP in those countries nevertheless. What about countries in transition? As top performers, Baltic tigers par the quality of business environment of advanced countries. Estonia is ranked 17^th, Latvia 22^nd and Lithuania 26^th. In central Europe, the ranking is much less competitive; Slovakia is ranked 32^nd, Slovenia 55^th, Czech Republic 56^th and Poland 74^th. Each year, Nordic countries constantly perform highly competitively. Taking a closer look on Nordic countries, the figures show that a typical Nordic business environment is almost completely free without hampering regulatory burden. Further, sophisticated and competitive access availability of venture and investment capital adds to the ease of doing business together with strong security contract validation and enforcement. Denmark’s flexible labor market free trade ranked it 5^th respectively, Iceland is ranked 10^th, Norway 11^th, Finland 13^th and Sweden 14^th.

DOING BUSINESS 2008

The newest World Bank's Doing Business is here.

The top five economies where doing business is the easiest are:
1. Singapore
2. New Zealand
3. United States
4. Hong Kong
5. Denmark
...

55. Slovenia

WEALTH MANAGEMENT OF SOVEREIGN FUNDS

Here is an advice to the managers of wealth funds of how transparency and diversified global investment portfolio generate returns without distortions and uncontrolled risk (link)

FRANCE'S EXCESSIVE REGULATION PROPOSAL WOULD DISTORT FINANCIAL MARKETS

"Capitalism without failure is like a religion without sin."

Allan Meltzer

France responded to recent turmoils and frictions in credit markets by calling for tougher and tighter regulation of global financial markets. Clearly, recent dynamics of credit markets and ECB's strongest intervention yet, reflect the turbulence and heating of risk over debt securities in avoiding speculation and credit default swamps which notably increase the probability of financial crisis (Mishkin, Herbertsson 2006).

The question is whether regulative pressures to disclose more of particular data and information about traded financial products could ease the credit flows and ensure more transparency. Since information is the most valuable tool in picking-up financial products to invest in particular assets with sufficient return predictions, adding trickier code laws would simply burden the ability of financial markets to catch growth momentum and enforce risk management rules to respond to the volatility of the level markets properly. Risk management is of course an important aspect of decision-making in globally competitive markets. In addition, pressures for more information disclosure would enforce control over credit and broadly financial markets.

Financial markets are faced by risks and shocks every day and failures which occur frequently could hardly be a reasons for imposing more regulation on decision-makers. One of the ways to confront risk-taking and risk-minimization measures is to ensure a broader access to particular funds, thus to provide sound sources of liquidity.

Recently, France's finance minister stressed (link):
"We have been proven right. We need more transparency and better governance in financial markets and we need it on a G-7 basis."

The evaluation of risk which investors and creditors face in the course of financial market, crucially depends on the ability to reduce the risk of biased information regarding decision-making in particular activity, say hedge fund industry or private equity investment. Transferring the liabilites of governance and transparency to a global body would fail already in the short-run because the amount of information needed to be absorbed and the lack of acceptance of risk in terms of responding to the outcome of the excessive regulation, are the prime reasons why globally enforced regulation would punish and penalize financial markets which could face significant distortions and risk aversion leading to lower returns and discounted ability to target particular markets with particular financial products respectively.

Recently published in Wall Street Journal, Allan Meltzer wrote a simple fact which politicians obviously can't understand:
"But whatever the perceived problem, more regulation is not the answer. It is far better to change some incentives for excessive risk-taking."

Because the regulation of credit and financial markets does not achieve stated objectives, information-sharing pressure reversingly forces equity investors, traders and market actors in particular financial industry to disclose the information required and this, in turn, leads to more complexity and government's control over the financial markets to go for an intervention which is perceived as a negative affection of stock market performance. For instance, could the regulation of carried risk in hedge fund industry really ensure more transparency if trading is conducted on the basis of contract deals where the treatment of information is regarded as contract stakers negotiate.

If the assessment of risk is perceived as low and underestimated, than the portfolio and price reassessment boosted by spontaneous market behavior would give bankers, traders and investors a far better incentive to re-evaluate the risk involving repackaged debt securities. A regulation such as proposed by France's policymakers rather induce external risk pressures to hit hedge fund industry, stock market and private equity firms, causing more harm than good.

The cinism of France's minister of finance is well seen:
"It's not a question of forbidding trading or barring market activity, it's making sure that the sophistication of financial products does not get so complicated that even investors dealing in those products are lost as to what they actually are."

So according to this statement, government officials know better how and where to allocate market resources to maximize the return from financial markets by purchasing traded products at agreeable conditions to traders and investors/purchasers. Market fluctuations are a daily reaction to innumerable decisions and contracts in the financial markets. The assessment of product sophistication could hardly be attached to government's responsibility. The proper degree and size of regulation is much better managed trhough contract deals at which both sides agree on terms and conditions involving particular products to take action in financial markets. In sum, transparency of particular financial products is the matter of the contractual enforcement and the reflection of dealing preferences and the overall efficiency of trading and financial markets always gets worse when government decides to intervene the market with excessive regulation whereas the cost adjustment is high; both for the cost of government and the private trading sector's ability to akin compliance burden.