The Big Picture

---

• Gates, Fees, and Preemptive Runs
• Bad Economic Policy Is Partly to Blame for Ferguson
• David Letterman Remembers Robin Williams
• 10 Tuesday PM Reads
• Oil Boom’s Effect On The U.S. Economy
• A Data Junkie Looks at the News
• 10 Tuesday AM Reads
• Quantifying the impact of chasing fund performance

Gates, Fees, and Preemptive Runs Posted: 20 Aug 2014 02:00 AM PDT Gates, Fees, and Preemptive Runs Marco Cipriani, Antoine Martin, Patrick McCabe, and Bruno M. Parigi Liberty Street Economics, August 18, 2014       In the academic literature on banks, "suspension of convertibility"—that is, preventing the exchange of deposits at par for cash—has traditionally been seen as a potential means of preventing economically damaging bank runs. In this post, however, we show that giving a financial intermediary (FI) the option to suspend convertibility may ultimately increase the risk of runs by causing preemptive runs. That is, investors who face potential restrictions on their future access to cash may run when they anticipate that such restrictions may be imposed. This insight is relevant for policymaking in today's financial system. For example, in July 2014, the Securities and Exchange Commission adopted rules that are intended to reduce the likelihood of runs on money market funds (MMFs) by giving the funds' boards the option to halt (or "gate") redemptions or to charge fees for redemptions when liquidity runs short, actions analogous to suspending the convertibility of deposits into cash at par. Our results show that the option to suspend convertibility has important drawbacks: A bank, MMF, or other FI with the option to suspend convertibility may become more fragile and vulnerable to runs. In other words, we show that instead of offering a solution, policies relying on gates and fees can be part of the problem. Preemptive Runs To formalize the intuition for why gates or fees may trigger runs, we consider a four-period model of the economy, as outlined in the exhibit below. Investors deposit money with the FI at date 0, for example, in the form of demand deposits that can be withdrawn at par or MMF shares redeemable at $1 each. The FI invests part of this money in a relatively illiquid asset—a bank might make a loan, while an MMF might purchase commercial paper—that matures at date 3. The FI's investment offers a positive rate of return that the FI can pass along to investors who withdraw at date 3. However, if investors withdraw before date 3, the FI incurs a substantial cost in liquidating the investment. Consider what happens if uncertainty suddenly develops about the return on the FI's investment. In particular, suppose that, at date 1, a portion of the FI's investors—call them "informed"— learn that the FI's investment returns are more volatile than originally thought. Let's also assume that both the FI and the informed investors will learn at date 2 whether the FI's investment has actually soured. At date 1, the informed investors have a choice. They can immediately redeem to obtain their cash, which would force the FI into a costly liquidation of the investment. Alternatively, they can wait for the uncertainty to be resolved, since a favorable outcome for the FI's investment will allow them to obtain a positive return at date 3. For the FI and the economy as a whole, having investors wait is clearly better. This would avoid costly liquidation and allow for the possibility that the investment might turn out to be profitable, in which case everyone will be (ex post) better off waiting until date 3. In fact, we show that under fairly general conditions, if the FI cannot suspend convertibility by imposing gates or fees on redemptions, informed investors will optimally decide not to run at date 1. Instead, they will wait until uncertainty is resolved at date 2, because waiting may allow them to partake of the positive return on the FI's investment if it turns out to be profitable. After all, these investors would still have the option of redeeming at date 2 if they learn that the FI's investment has turned out to be bad. But what happens if the FI can impose a gate or fee at date 2? We show that if the FI's investment turns out to be bad, the FI will exercise its option to impose gates or fees on investors at date 2. In this case, informed investors may obtain less than what they originally deposited with the FI, because they must share the loss with the FI's other investors. This risk causes informed investors to run preemptively from the FI at date 1 in anticipation of the possibility that convertibility may be restricted at date 2. Conclusions We prove these points more formally in a recent Federal Reserve Bank of New York staff report. There, we use a traditional model of financial intermediation to demonstrate the basic proposition discussed in this post: Giving an FI the option to impose gates or fees may be destabilizing because the option itself can trigger damaging runs that otherwise would not have occurred. This result is likely to hold for a variety of adjustments to the assumptions in our model, because the intuition is stark: The possibility of a fee or any other measure that is costly enough to counter investors' strong incentives to run amid a crisis will give investors a strong incentive to run preemptively to avoid such measures. Even though our model does not address how runs on FIs can create large negative externalities for the financial system and the real economy, one important policy implication is clear: Giving FIs, such as MMFs, the option to restrict redemptions when liquidity falls short may threaten financial stability by setting up the possibility of preemptive runs. Disclaimer The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Marco Cipriani is a research officer in the Federal Reserve Bank of New York's Research and Statistics Group. Antoine Martin is a vice president in the Bank's Research and Statistics Group. Patrick McCabe is a senior economist in the Division of Research and Statistics at the Board of Governors of the Federal Reserve System. Bruno M. Parigi is a professor of economics at the University of Padua.

Bad Economic Policy Is Partly to Blame for Ferguson Posted: 19 Aug 2014 10:30 PM PDT The Terrible Handling of the Economic Crisis Is a Cause of the Ferguson Riots   We noted 3 years ago that the terrible handling of the economic crisis would lead to civil unrest and riots. We noted that: A study this month by economists Hans-Joachim Voth and Jacopo Ponticelli showsthat – from 1919 to the present – austerity leads to violence and instability: Does fiscal consolidation lead to social unrest? From the end of the Weimar Republic in Germany in the 1930s to anti-government demonstrations in Greece in 2010-11, austerity has tended to go hand in hand with politically motivated violence and social instability. In this paper, we assemble cross-country evidence for the period 1919 to the present, and examine the extent to which societies become unstable after budget cuts. The results show a clear positive correlation between fiscal retrenchment and instability. We test if the relationship simply reflects economic downturns, and conclude that this is not the key factor. We also analyse interactions with various economic and political variables. While autocracies and democracies show a broadly similar responses to budget cuts, countries with more constraints on the executive are less likely to see unrest as a result of austerity measures. As CNN notes: Studying instances of austerity and unrest in Europe between 1919 to 2009, Ponticelli and Voth conclude that there is a "clear link between the magnitude of expenditure cutbacks and increases in social unrest. With every additional percentage point of GDP in spending cuts, the risk of unrest increases." "Expenditure cuts carry a significant risk of increasing the frequency of riots, anti-government demonstrations, general strikes, political assassinations, and attempts at revolutionary overthrow of the established order. While these are low probability events in normal years, they become much more common as austerity measures are implemented." The looting and chaos in Ferguson, Missouri is not justifiable … but it's largely caused and inspired by the looting on Wall Street. As basketball great Kareem Abdul-Jabbar notes, this isn't a race war … it's a class war.  And corrupt government policy is largely to blame.

David Letterman Remembers Robin Williams Posted: 19 Aug 2014 07:00 PM PDT Dave pays tribute to the great Robin Williams.

10 Tuesday PM Reads Posted: 19 Aug 2014 01:00 PM PDT My afternoon train reads: • Don’t fall into the trap of ignoring investment risks to chase returns (Financial Post) • Stock Returns: Between Shiller and DeLong (CEPR) • heh heh Legends of the financial blogosphere (Yahoo Finance Contributors Tumblr) • How long will the expansion last? (Economist) • For Interest Rates, Low Is the New Status Quo (MoneyBeat) see also How Much U.S. Debt Does China Hold? The U.S. Isn’t Sure (Real Time Economics) • Ronald Reagan Steals the Show (Bloomberg) • Five TED Talks Every MBA Student Should Watch Today (Bentley Masterminds) • It Matters How Rich the Rich Are (Demos) see also Being poor changes your thinking about everything (WonkBlog) • E-Bike Sales Are Surging in Europe (NYT) • The Biggest Lesson I Learned as an Apple Designer (Inc) see also Life after death: Resuscitating a drowned iPhone 5 (Mac World) What are you reading?     Americans are taking fewer vacations than they used to Source: Vox

Oil Boom’s Effect On The U.S. Economy Posted: 19 Aug 2014 11:00 AM PDT Source: Deloitte

A Data Junkie Looks at the News Posted: 19 Aug 2014 08:00 AM PDT Many years ago, when I was a poor and humble graduate student, I taught the prep course for students taking the GMATs and LSATs. I understood the internal logic and game theory needed to succeed on standardized tests, and could explain techniques used to do well on them. One of the keys to succeeding on these tests was to have strong reading comprehension skills. Toward that end, I taught what I like to call active reading. It required the reader to approach text in a rigorous and logical way, challenging each sentence to find assumptions, false statements and deductive errors. Think of it as logical skepticism. I still use these muscles everyday. I can randomly pick up any newspaper article or analyst report, and find holes and flaws merely by asking questions the author left unanswered. Active reading often leads to the conclusion that the vast majority of news is at best incomplete and uninformative, while a majority of research reports are full of biases and logical errors. That is a pretty bold statement, and to demonstrate this, I am going to take a random article and dissect it using logical skepticism. When I am finished, you will have a better understanding of why I often say "Lose the News." I hope you never look at media noise in the same way. Yesterday, an article decided to take stock of investors’ concerns, quoting many strategists and managers. I chose it because it was well-written and researched, and offered the perspectives of many strategists. However, this exercise can be done with any article or research piece written by anyone anywhere. Continues here

10 Tuesday AM Reads Posted: 19 Aug 2014 06:30 AM PDT Here are our morning reads, sourced exclusively from a craft brewer located in Brooklyn (continues here): • Before Jackson Hole, roundup of Yellen’s quotes on the labor market (FT Alphaville) see also Part-Time Workers a Full-Time Headache on Yellen Radar (Bloomberg) • Morningstar: A force to be reckoned with (FT) • All You Need to Know About Emerging Markets (Irrelevant Investor) see also The Other Great Rotation (Barron’s) • Shoddy U.S. roads and bridges take a toll on the economy (LA Times) Continues here

Quantifying the impact of chasing fund performance Posted: 19 Aug 2014 03:00 AM PDT

You are subscribed to email updates from The Big Picture To stop receiving these emails, you may unsubscribe now.	Email delivery powered by Google
Google Inc., 20 West Kinzie, Chicago IL USA 60610

.