Recently in finance Category

On Risk and Gambling

From the Deseret News on Tuesday.

This past week the U.S. Commodity Futures Trading Commission issued a complaint against the online prediction market firm Intrade. Intrade is based in Ireland, so the complaint does not shut down the company, but it does effectively lock out U.S. residents from participating in the market. The ostensive reason for the complaint is that Intrade has been offering off-exchange options, which seems to mean that it has been offering online gambling.
From the Deseret News this last Tuesday.

A few years back I volunteered at an archeological site in Range Creek, Utah.  I learned that archeology is arguably the most interdisciplinary subject in the world.  And I learned that I don't have the eyesight or the tolerance for dust needed to succeed in that field.  I also learned an interesting lesson about the interesting ways that economic thinking can inform our understanding of societies, even ones that leave no written history.

Forecasting the Presidency

From the Deseret News, September 4, 2012

You may have noticed there is a presidential election coming up.  The Republican Party met this past week in Tampa, Florida and officially nominated Mitt Romney as their candidate.  Democrats are meeting this week in Charlotte, North Carolina to renominate President Barack Obama.  Of course all that really matters is the counting of electoral college votes, and those will be decided on November 6th.

In the meantime, however, it is at least entertaining to try and predict which candidate will win.  There is no shortage of opinion, of course.  In the past week I have read that an Obama win is a sure thing, that Romney is sure to win, and that the election is too close to call.

From the Deseret News this last Tuesday.

In terms of public opinion, the past couple of years have not been kind to people who work in financial markets.  The subprime mortgage meltdown and recession have generated negative feelings among a substantial number of Americans toward financial markets and the people who profit from them.  Recent rhetoric in the Republican presidential primaries concerning Mitt Romney's role at Bain Capital and Bain's role in the economy has revived the issue.

What Lies Ahead for North Korea?

This article appeared in the Deseret News on December 27th.

Kim Jung-il, the ruler of North Korea, died last week, reportedly of a massive stroke.  Other than a few deluded souls who might have been sincerely crying their eyes out on North Korean television, he will be missed by no one.

His death does, however, open up the possibility of changes in that reclusive country's policies, both domestically and internationally.  In terms of politics and policy, North Korea is probably the hardest country in the world to reliably understand.  We can observe the final results of whatever process determines policy, but very few people outside North Korea have any clue how that process actually proceeds.  So it is entirely possible that nothing will change in practical terms as a result of Kim Jung-il's death.  Still, if you are a bit of a gambler, the odds are higher now than they have been in a long time.

This article, by Rick, came out in the Deseret News on December 20th.

Eyebrows raise when you hear about any interest rate on credit more than 30 percent. If you're discussing payday or title lending, the implied interest rates (in annual percentage rate) can be above 500 percent. Put in those terms, short-term consumer lending markets sound immoral and predatory.

What is a Currency?

What is Bitcoin? from CNBC, July 20, 2011

Currencies are normally issued by governments and are backed either by a commodity or by a legal mandate.  But Bitcoin is backed by neither.  In fact, it does away with a financial intermediary almost entirely.  Unlike Paypal or other online monies, Bitcoin is peer-to-peer exchange of "tokens."  The Bitcoin transfer protocol is the only intermediation that occurs.

"The process also lets people conduct transactions with virtual (but not complete) anonymity, perhaps the biggest key to its success so far. And as online transactions continue to grow and online data theft becomes a more common occurrence, bitcoin backers see an opening for the system."

"The bitcoin system is designed so there will never be more than 21 million bitcoins in existence.  Every four years, the number of new coins that will spring into existence--or be mined--will be cut in half, until the supply is exhausted in approximately 2030. After that, the only way to get bitcoins will be via exchanges. (At present, there are about 6.6 million in circulation.)."

"The value of bitcoins in real world dollars fluctuates wildly--often as much as 8 percent per day. As little as two months ago, the exchange rate was $1 USD per bitcoin. That was before the mainstream world learned about them, though--which sent their value through the roof.  Speculators quickly saw potential in this new currency and began buying them through Mt. Gox and other sites. Given the currency's instability, that led to rapid inflation and the currency value peaked at nearly $28 on June 9.  These days, you can expect to pay somewhere between $15 and $20 per bitcoin."
This article appeared in the Deseret News on Aug. 23, 2011

Switzerland is having currency problems. This may come as a surprise to many people, since unlike a number of other countries that are in the news these days, the Swiss have been financially responsible. However, as government debt problems have roiled many nations in Europe and the US has struggled with its own government debt ceiling, many investors have turned to Switzerland as a relatively safe investment haven.

The problem with this from the Swiss point of view is what it has done to the exchange rate. Because investors want Swiss financial assets, the demand for Swiss francs on the world market has expanded dramatically. The result has been a surge in the value of the franc over other currencies. A franc is worth 50% more euro today that it was two years ago, and is worth almost 60% more dollars than it was in December of 2008.

For Swiss tourists and importers this is a huge gain; their relative wealth has surged with the exchange rate and foreign goods look much less expensive than the used to. For Swiss firms this is a disaster; for their customers the prices of their goods have risen right along with the value of the franc. As a consequence, sales and orders have dropped off dramatically.

As a result, Swiss policy makers have begun making public statement about a possible pegging of the franc to the euro. This would require a big increase in the Swiss money supply, but it would bring the exchange rate back down.

This is one recent illustration of the importance that exchange rates play in our modern economy. They are particularly important for smaller countries like Switzerland. Countries have a variety of options when it comes to exchange rate policy. All of these, however, are simply variations on two opposites. Countries can choose to fix their exchange rate to another currency or to a commodity (historically, gold) or they can let the value of their currency float on the market.

Since the early 1970s, the Swiss franc has been a floating currency along with the other major "vehicle" world currencies, the US dollar, the euro, the British pound and the Japanese yen. A floating exchange rate gives the central bank issuing the currency complete control over its own money supply. The bank may create more money when it feels the economy needs a stimulus, or create less money if they feel inflation is beginning to become a problem. However, the central bank cannot control the exchange rate in this case. Exchange rates in this case are set in the foreign currency market by the interaction of supply and demand for the domestic currency and the central bank buys and sells in this market only rarely. Indeed, most central banks with floating currencies lack the foreign currency reserves needed to manipulate the exchange rate.

Some countries rigidly peg the value of their currency to another. Hong Kong, for example, pegs the value of the Hong Kong Dollar to the U.S. dollar at a rate of 7.8 HKD per USD. When a country pegs it ends up in the exact opposite position as above. The central bank can choose any value it wants for the exchange rate, but it loses control over its own money supply. It is forced to create an exact amount of new money each year that will keep the exchange rate fixed. If demand for the currency suddenly surges, the bank must create enough money to meet this demand. Central banks that peg the value of their currencies are forced to constantly buy and sell in the foreign exchange market to keep the price constant. When demand for their currency rises, they sell it and buy foreign currencies. When demand falls they buy their own currency and sell foreign reserves.

Most international financial crises over the past several decades have arisen because of central banks attempting to manipulate their money supplies while maintaining a fixed exchange rate. The collapse of the European Exchange Rate Mechanism in 1992, the Mexican peso crisis of 1994 and the Argentina currency board collapse in 2002 are three memorable examples. All were ultimately caused by countries attempting to hold exchange rates fixed, while at the same time engaging in independent monetary policies.

Could we see a similar currency crisis in the near future? Not with the U.S. dollar which freely floats. We could certainly see the value of the dollar drop if supplies expand or demand for the dollar drops, but we are unlikely to see the catastrophic overnight drops associated with a full-blown currency crisis. Europe, on the other hand, does have a fixed exchange rate system in that many different countries all use the same currency. Given the fiscal problems in Greece, Ireland, Portugal, Spain, and other countries in the Euro area, a currency crisis associate with a country dropping out of the euro pact is a real possibility.
This article appeared in the Deseret News on June 14th, 2011

Last month the managing director of the International Monetary Fund (IMF), Dominique Strauss-Kahn, was arrested in New York. The extensive coverage of that case has led to increased scrutiny of the IMF as an institution. The IMF is an important institution in international banking and finance, but few people realize what the IMF does and why it matters.

The IMF was created near the end of World War II. In July 1944, delegates from the Allied nations met at the Mount Washington Hotel near Bretton Woods, N.H.. The conference was called to set up an international financial system that would stabilize the world economy once the war was over. The need for stability had been clear as early as World War I, when most major nations abandoned the gold standard. The successive turmoils of the Great Depression and World War II made reestablishment of a gold-based system impossible. The Bretton Woods agreement put the world back on an international gold standard.

Three major international institutions were created as a result of the Bretton Woods Agreement. The World Bank was established to aid in the reconstruction of countries in Europe and Asia that were severely damaged by the war. The General Agreement on Tariffs and Trade (GATT), now known as the World Trade Organization (WTO), was set up to negotiate reductions in high tariff barriers that had been erected during the 1930s. Finally, the IMF was established to help maintain the stability of the fixed exchange rate system.

Most fixed exchange rate systems are subject to speculative instability that is very similar to a bank run. When a run occurs on a bank it is because of widespread beliefs on the part of depositors that the bank lacks sufficient cash on hand to pay out the small number of depositors who would normally withdraw their money in the short-run. As George Bailey explained so well in "It's a Wonderful Life," the deposits in a bank are backed mostly by loans and only a small amount of cash is kept on hand. When depositors fear the cash is going to run out, they all run to the bank and withdraw. This quickly depletes the cash on hand and the bank can become insolvent. Historically, to reduce the likelihood of bank runs, we have instituted deposit insurance and created lenders of last resort, i.e. central banks. They provide cash that the bank does not have on hand during a run and allow depositors to be paid off if they wish. Knowing that the lender of last resort exists and will act if needed is often sufficient to stop a bank run from happening in the first place.

Similarly, when countries fix the value of their currencies they can be subject to speculative attacks. Central banks that fix their exchange rates must constantly buy or sell foreign currency reserves to smooth out fluctuations in the supply and demand for their own currency. Suppose holders of Thai baht believe the Thai central bank will soon run out of U.S. dollars. They also realize the value of the baht will fall. To avoid this loss they attempt to convert their baht to dollars now -- just like a run on bank deposits. The IMF was created to be an international lender of last resort; a sort of central bank for central bankers. When a speculative attack occurred the IMF was supposed to step in and provide needed foreign reserves from its fund (hence the name).

The fixed exchange regime set up at Bretton Woods was abandoned in the early 1970s. And the main purpose for the IMF's existence disappeared at the same time. With floating exchange rates, central banks need never run out of foreign currencies, because they don't really need to buy or sell them.

So what does the IMF do under our current international system? Despite abandoning fixed exchange rates in general, many countries still fix the value of their domestic currencies to others. Sometimes this pegging is formal -- as in the case of Hong Kong -- and sometimes it is informal. The IMF played an important role in supplying needed foreign reserves to Asian countries in 1997, for example. Sometimes countries experience financial turmoil unrelated to exchange rates, and the IMF is increasingly involved in restructuring sovereign debt. The most recent example of this is the crisis in Greece, and looming crises in Spain, Ireland, Portugal and elsewhere.

While these services are useful, they could be provided by other international institutions or governments, even by private parties in some cases. The IMF's main purpose for existing vanished 35 years ago, but the IMF is likely to remain an important international institution for the foreseeable future.

Authors

  • Richard W. Evans is an Assistant Professor of Economics at Brigham Young University

  • Jason DeBacker is an Assistant Professor of Economics at Middle Tennessee State University

  • Kerk L. Phillips is an Associate Professor of Economics at Brigham Young University