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Crisis instrument central bank swaps

In a recent article, Perry Mehrling drew attention to the global network of central bank swaps:

“In the last few weeks, the ECB has been drawing on its liquidity swap line with the Fed, first $308 million for a week, then $658 million for a week, and last week back down to $358 million. What’s that about?
It’s not such a large amount. Bank of Japan borrowed more in the past, $810 million in March and $1528 million in January. But the question then repeats, what was that about?
Both of these drawings are part of the new set of central bank swap lines linking what I call the C6: the Fed, ECB, Bank of Japan, Bank of England, Swiss National Bank, and Bank of Canada. On October 31, 2013 these lines were made permanent and unlimited … Ever since then I have had a slide in my powerpoints saying “Forget the G7, Watch the C6.””

So, what is going on here?

As Perry Mehrling noted, central bank swaps are in some ways similar to a standard commercial foreign exchange swap. But, there are also differences.

A commercial swap is an exchange of two currencies for a specific period with a reversal of that exchange at the end of the period. It consists either of a combination of a spot and a forward leg or of two forward trades with different maturities. The cost is the swap rate, which is the difference between spot and forward rate (or between the two forward rates involved). This in turn is equal to the interest-rate differential for a given term. The swap rate is always paid to the holder of the currency with the lower interest rate.

Swaps can be used either to avoid or take foreign exchange risk. For example, a company which is expecting a payment in a foreign currency at some future date may wish to lock in the current exchange rate by buying the respective amount spot and at the same time selling it forward to the day when it may settle the trade with the incoming payment. On the other side, as I wrote elsewhere, swaps can be used to prolong an open position exposed to foreign exchange risk in search of a currency profit.

Central bank swaps differ from these kinds of transactions in several respects.

First of all, they are instruments of monetary policy. They are based on official reciprocal arrangements of swap lines which allow a future exchange of one currency for another under certain conditions:

“Swaps lines between central banks enable the receiving central bank … to obtain foreign currency liquidity from the issuing central bank. Such agreements have been part of central banks’ set of monetary policy instruments for decades. Their primary use was originally to temporarily affect the domestic liquidity situation when other instruments would not serve the purpose or to temporarily and indirectly influence foreign exchange rates. In addition, foreign exchange swaps have been used to allow central banks to acquire foreign exchange to fund interventions.” (ECB)

Furthermore, central bank swaps differ from commercial swaps in that they may require prior notice and may have a maximum duration. (See for this and the following, for example, the documents in the Federal Reserve Central Bank Liquidity Swaps Arrangements Archive).

In addition, as Perry Mehrling observed, “the forward rate in the contract is usually exactly the same as the current spot exchange rate. This means that central banks are never in the position of realizing profits or losses from the swap. … Usual practice has been for the party who draws on the line to pay interest on the line at some penalty rate. Thus the May 9, 2010 swap agreement between the Fed and ECB called for the ECB to pay the USD Overnight Index Swap Rate plus 100 basis points on its dollar borrowing, and the Fed to pay nothing on its euro borrowing. In effect, the ECB was simply borrowing dollars at the discount window, like any other bank, but with its own monetary liability serving as collateral instead of some financial asset.”

There are risks. The Council on Foreign Relations wrote: “While the terms of swap agreements are designed to protect both central banks involved in the swap from losses owing to fluctuations in currency values, there is some risk that a central bank will refuse, or be unable, to honor the terms of the agreement. For this reason, lending through currency swaps is a meaningful sign of trust between governments.”

Central bank swaps have a long history. The ECB mentioned that until the 1990s, the Fed maintained an extensive network of foreign exchange swap lines with various central banks and the BIS. (The swap lines with central banks of euro area countries were discontinued with the introduction of the single currency in 1999.)

Initially, swap lines were mainly intended to increase central banks’ financial scope to fight a currency crisis. While, in principle, a central bank’s means to counter an appreciation of the domestic currency – which it can issue itself– is unlimited, its ability to cope with an ongoing devaluation is determined by the level of foreign reserves. The idea behind swap lines was to alleviate this problem as they widen the available pool of funds.

CB-Swaps Chart-FX-turnoverIn a market with a $5.3 trillion estimated average daily trading volume, however, the concept has never been tested in earnest. Not even the wide dollar/euro swings in recent years have tempted the authorities in Europe and the US to intervene on a scale that would have required the use of a swap line. Rather it is as Perry Mehrling observed that “smaller sums are becoming a routine way of handling the normal stresses and strains of world funding flows.”

There has been one exception, however. The table below shows the amounts borrowed from the Fed by other C6 members at selected dates. The series dates back to May 2010. With the exception of smaller drawings by the SNB in 2011 and 2012, only the ECB and – to a lesser extent – the Bank of Japan have been making use of Fed swap lines so far. The selection here draws attention to the one occasion where this use was extensive. It started in September 2011 and lasted until summer 2013.

CB swap dollar_euro

In the course of the European debt crisis, during this time, the ECB borrowed dollars from the Fed and lent them on to banks in Europe who had dollar liquidity needs and were unable, as Perry Mehrling wrote, ”for whatever reason, to access dollar funding in the open market, or only at a premium … higher than the ECB charges”. At its peak in February 2012, the ECB had $89,698 million outstanding swaps with the Fed. This and the BOJ’s $20,473 million in January 2012 dwarf the sums mentioned by Perry Mehrling for both central banks in 2015.

CB-Swap Table FedIn the second half of 2012, the situation began to calm down as “banks’ actions to address the ESRB’s recommendations, the progress in the euro area in terms of fiscal consolidation, economic recovery and structural reforms, and the continuous provision of unlimited US dollar funding all contributed to the normalization of the US dollar funding markets for euro area banks. Demand for the regular US dollar tenders dropped throughout 2012 and remained very limited in 2013.” (ECB: Experience with Foreign Currency Liquidity-providing Central Bank Swaps)

The incident indicates a shift in focus of the use of central bank swap lines in major markets. Instead of providing liquidity to economies “when other instruments would not serve the purpose”, and intervening to dampen currency fluctuations, helping out domestic banks came to the fore:

“Since the onset of the financial crisis in 2007, bilateral central bank swap lines allowing the provision of foreign currency to local counterparties have become an important tool of central bank international cooperation to prevent systemic risk and limit contagion across major currencies. The design and calibration of the operations used by the ECB to provide foreign currency liquidity to domestic banks helped to achieve the key objectives of the swap lines and calmed markets and funding concerns during the crisis … (ECB).”

The reference to systemic risk and contagion can hardly disguise the fact that here the Fed was de facto “bailing out” European banks, as critics remarked.

CB swap agreements1Since the financial crisis of 2007, central banks around the world have entered into a multitude of bilateral currency swap agreements with one another. The Council on Foreign Relations traced their history:

“On December 12, 2007, the Federal Reserve extended swap lines to the European Central Bank (ECB) and Swiss National Bank (SNB). European bank demand for dollars had been pushing up, and creating accentuated volatility in, U.S. dollar interest rates. The swap lines were intended “to address elevated pressures in short-term funding markets,” and to do so without the Fed having to fund foreign banks directly [my emphasis].

On September 16, 2008, two days after the collapse of Lehman Brothers, the Federal Reserve Open Market Committee (FOMC) gave the foreign currency subcommittee the power “to enter into swap agreements with the foreign central banks as needed to address strains in money markets in other jurisdictions.” This enabled the subcommittee to extend swap lines to other central banks and to expand the size of the existing swap lines, without the need for the full FOMC to vote on it. … Two days after the subcommittee was granted this power, the Fed expanded the size of the swap lines with the ECB and SNB, and extended three new swap lines, to Canada, the United Kingdom (UK), and Japan. On September 24, 2008, further swap lines were extended to Australia, Denmark, Norway, and Sweden. On October 28, 2008, a swap line was extended to New Zealand.

CB swap agreements2The ECB established swap lines with Sweden in December 2007, the SNB and Denmark in October 2008, and the Bank of England in December 2010. The euro area, Sweden, Denmark, and the UK had relatively low foreign exchange reserves going into the crisis, owing to the costs involved in holding reserves and the belief that there was little likelihood that more would be needed in the foreseeable future. However, banks in these countries borrowed large sums in foreign currencies in the years leading up to the crisis. When it became difficult for them to borrow funds in 2008, they turned to their central banks, reserves of which proved insufficient to meet the unanticipated demand. The ECB swap lines were therefore called into use in 2009 to provide Sweden and Denmark euros with which to top up their foreign exchange reserves, and the swap line with the SNB was called upon to provide the ECB with Swiss francs. The swap line with the Bank of England was put in place as a precautionary measure to ensure that the Central Bank of Ireland, which is part of the Eurosystem, had access to pounds sterling, but it has never been used. Since 2007, Sweden and Denmark have more than doubled their foreign exchange reserves, the UK has doubled its reserves, and the euro area has increased its reserves by 20 percent.

In 2011, the Bank of Canada, Bank of England, European Central Bank, Bank of Japan, Federal Reserve, and Swiss National Bank announced that they had established a network of swap lines that would allow any of the central banks to provide liquidity to their respective domestic banks in any of the other central banks’ currencies. In October 2013, they agreed to leave the swap lines in place as a backstop indefinitely”.

Perry Mehrling commented: “For lack of a world central bank, we have a network of central bank liquidity swaps.”

CB swap agreements3Other swap agreements worth mentioning include the Chiang Mai initiative which was established after the 1997–98 Asian financial crisis. It started as a network of bilateral currency swap agreements between the members of the Association of Southeast Asian Nations (ASEAN), China, South Korea, and Japan. Here is once more the Council on Foreign Relations:

“In 2010, the Chiang Mai Initiative (CMI) was multilateralized, meaning that it was converted from a network of bilateral agreements between countries into one single agreement, the Chiang Mai Initiative Multilateralization (CMIM). A surveillance unit, the ASEAN+3 Macroeconomic Research Office (AMRO), was created to monitor member economies for signs of emerging risks and to provide analysis of countries requesting funds from the CMIM, much as the International Monetary Fund (IMF) does for its member countries. The fourteen countries participating in the CMIM agreed to a certain financial contribution and were thereafter entitled to borrow a multiple of this, ranging from 0.5 for China and Japan to five for Vietnam, Cambodia, Myanmar, Brunei, and Laos. In 2014, the size of the agreement was doubled from $120 billion to $240 billion, and the amount a country could access without being on an IMF program was raised from 20 percent to 30 percent.

These swap lines have never actually been used. Even during the financial crisis, when Korea was drawing as much as $16.4 billion from its swap line with the Federal Reserve, neither Korea nor any other country that was party to these agreements used them to obtain foreign currency. While the amounts available through Chiang Mai were potentially large enough to significantly augment a country’s reserves, IMF conditionality (for borrowing beyond 20 percent of a country’s quota) was a major deterrent to using Chiang Mai funds; in contrast, borrowing the full amount available through the Fed’s swap lines did not require any kind of IMF program.”

The Council on Foreign Relations also drew attention to another network of bilateral currency swap agreements in the region, and this one has been used extensively due to special circumstances:

“Since 2009, China has signed bilateral currency swap agreements with thirty-two counterparties. The stated intention of these swaps is to support trade and investment and to promote the international use of renminbi.

Broadly, China limits the amount of renminbi available to settle trade, and the swaps have been used to obtain renminbi after these limits have been reached. In October 2010, the Hong Kong Monetary Authority and the People’s Bank of China (PBoC) swapped 20 billion yuan (about $3 billion) to enable companies in Hong Kong to settle renminbi trade with the mainland. In 2014, China used its swap line with Korea to obtain 400 million won (about $400,000). The won were then lent on to a commercial bank in China, which used them to provide trade financing for payment of imports from Korea.

In addition to using the swaps to facilitate trade in renminbi, China is also using the swap lines to provide loans to Argentina in order to bolster the country’s foreign exchange reserves. In October 2014, a source at the Central Bank of Argentina reportedly told Telam, the Argentine national news agency, that the renminbi Argentina receives through the swap could be exchanged into other currencies. Argentina has had difficulty borrowing dollars on international markets since it defaulted on its debt in July and has faced shortages on a range of imported goods as a result.”

China’s swap lines 2009 and 2015


Given the size of world financial and foreign exchange markets these days, the original idea of establishing central bank swap lines to widen the pool of funds to fight a currency crisis has hardly any chances for success. As impressive as the figures quoted by Perry Mehrling look at first glance, they would never suffice to stem the flood of currency flight and massive speculation.

But, as the above examples show, the nature of central bank swaps as an instrument of monetary policy has fundamentally changed in recent years.

Central banks use swap lines

– to strengthen political ties,
– pursue reserve-currency ambitions,
– undertake rescue operations for domestic banks,
– to keep together a currency union which is in danger of falling apart,
– and bail out foreign banks to mitigate the risk of contagion.

It is in this context that the word “unlimited” in the C6 agreement gives rise to concern.


ECB: Experience with Foreign Currency Liquidity-providing Central Bank Swaps
Federal Reserve Foreign Exchange Swap Agreements
Federal Reserve press release May 11, 2010
Central Bank Liquidity Swaps Arrangements Archive
Transcript of the Federal Open Market Committee Conference Call of December 6, 2007
Meeting of the Federal Open Market Committee on September 16, 2008

An emergency currency regime for Greece

With the agreement of the Eurogroup to accept the Greek reform proposals the latest crisis in the euro area seems averted – for the moment. Apparently, Greece had no other option than to give in and prolong its current bailout program as requested or leave the monetary union. The latter would have been a complete surrender to the challenges of a common currency – not of Greece but of its European “partners”. All can-kicking in recent years, all refusals to face the needs of a functioning monetary system, all costly bank bailouts to prevent a destabilization of national financial markets and policy structures, and all sacrifices made by individual countries under harsh austerity constraints in order to “save the euro” might have been fruitless as a Grexit inevitably would have triggered a chain reaction among other member countries and possibly the union’s breakup.

DrachmeThe danger is not banned yet: Gabriele Steinhauser (Wall Street Journal) wrote immediately after the official consent that the IMF and others still have concerns over the seriousness of the reform measures. Alkman Granitsas (Wall Street Journal) listed five things to know about Greece’s proposed reforms which its creditors might not expect or approve. And in order for the funds to be released the program must be implemented successfully and all its conditions met.

How real is the risk of a Grexit under these circumstances? In principle, no one could force Greece to leave the eurozone. As Phoebus Athanassiou wrote in an ECB Legal Working Paper: “[W]hile perhaps feasible through indirect means, a Member State’s expulsion from the EU or EMU, would be legally next to impossible.” And voluntarily they would not go. Polls show that up to 80 percent of Greeks want to keep the euro. This is the dilemma Greek Prime Minister Alexis Tsipras is facing, as the NZZ noted the other day. On the one hand most Greeks were supporting his unbending attitude in negotiations with the Eurogroup. On the other hand, they want to keep the euro which, as almost everybody is telling them, would have been impossible if he had succeeded. The question is, however, whether in this special case the Greeks eventually could not both have their cake and eat it.

Let us take stock. Greece is a small country in a monetary union which is both politically and economically largely dominated by Germany and a couple of other members. The adoption of an artificial common currency and centralized monetary policy is a unique experiment which prevents the Greek government from adjusting the exchange rate to domestic needs. Despite this restraint – and in contrast to the many myths prevailing in public debates – Greece managed to achieve an extraordinary economic performance in international comparison in recent years. Its fiscal consolidation is the fastest among European countries. Its change in overall responsiveness to Going for Growth recommendations has been the highest among OECD countries. It is leading the OECD reform ranking. Its government revenue in percent of GDP is rising. Its competitiveness as measured in Unit Labour Costs is higher than the euro average. (See Brian Lucey‘s collection of charts for these and other figures.)

As Greece’s Finance Minister Yanis Varoufakis told the Eurogroup (quoted by Tim Worstall, Forbes):

“We are committed to sound public finances. Greece has made a vast adjustment over the past five years at immense social cost. Its deficit is now below 3% in nominal terms, down from 15% in 2010. Its primary surplus has reached 1.5% at the end of last year, its structural balance, as measured by the IMF, has reached a surplus of 1.6%, the best performance in the EU.“

Solvency and liquidity

Above all, Greece is facing two major problems:

1. The country won’t ever be able to pay off its debts with austerity as Brendan Greeley (Bloomberg) argued convincingly and Michael Pettis explained in a more fundamental way.

2. A widespread fear of Grexit and currency conversion, which brings Greeks to withdraw cash from their banks and drives private capital out of the country, strongly limits the scope for policy action.

A bank run is the greatest immediate danger. In what the Wall Street Journal called The Greek Re-Vote in February an estimated €2 billion (others talked of €5 billion) was leaving the country each week already. Maybe the prospect of an ever larger number of bank customers withdrawing their deposits and the resulting threat of bank illiquidity was the main reason for the U-turn of the Greek government accepting the Eurogroup deal in contrast to earlier statements.

Observers wondered about the role of the ECB in this situation. Guntram B. Wolff (Bruegel) pointed to the fact that “[i]n a normal bank-run, a central bank needs to provide unlimited liquidity to allow all depositors to withdraw their cash if they wish to. For the Greek banking system, the theoretical limit would be the size of all deposits. … The Greek banking system has a pretty large deposit base of 243.8 billion (December 2014).”

Although recently the ECB increased its amount of Emergency Liquidity Assistance (ELA) from 60 billion to 65 billion the question arose whether it would be prepared to go beyond this and act as a lender of last resort to the whole system. Guntram B. Wolff wrote:

“[M]y answer would clearly be “it depends”. If there is certainty that Greece stays in the euro, its banks remain solvent and a political compromise is reached, then the answer is an unambiguous “yes”. More problematically, if there is a clear political consensus that no agreement between euro area partners can be found, then the ECB cannot provide unlimited funding. The reason is simply that the ECB would know that in the case of a certain exit, the Greek banks would be insolvent as the economy is collapsing and therefore the value of the assets of the banks would be inferior to the liquidity provided. And even if Grexit wasn’t certain but government default was, parts of the banking system would be insolvent requiring limits on ELA.”

What would happen if Greece would run out of funds? Nikolaos Chrysoloras, Marcus Bensasson and Christos Ziotis (Bloomberg) described How a Liquidity Squeeze Could Push Greece Out of the Euro. In this case Greece would not only be unable to further service its international debt obligations. State and banks would no longer be able to adequately provide the economy with cash. Government would be forced to cut expenditures and also to establish a new currency to secure payments. Many would regard this as a first step to a de-facto exit from the euro area and a return to the drachma.

But maybe there is still another option: New currency could be introduced in parallel to the euro explicitly for a limited time and a well-defined limited purpose with the intent to return to the status quo ante as soon as political and economic prospects do no longer cause panic and anxieties, confidence in the ECB’s lender-of-last-resort function is restored and capital flows are reversed.

Parallel currency

In the past, there have been several proposals to introduce a parallel currency as a solution to the Greek dilemma. Sven Böll (Der Spiegel) reported on a blatant sort of cleansing approach which aimed at ejecting Southern European crisis countries from the monetary union “in a civilized way”. Accordingly, not only the drachma but also peseta, lira and escudo would be brought back alongside the euro. Their countries’ national central banks would tie these currencies to the euro at fixed rates which would allow them “to remain connected to the euro and devalue their currencies and still have a calculable form of payment at their disposal.” … “Withdrawal from the euro would take place “in an orderly and certainly cautious manner,” and could possibly be reversed after a few years through a complete return to the monetary union.”

Another concept to separate the wheat from the chaff via parallel currencies was proposed by Thomas Mayer, former Chief Economist of Deutsche Bank Group and Head of DB Research, and now a senior fellow at the Center for Financial Studies at Goethe University Frankfurt and external adviser to Deutsche Bank. Considering the likelihood of a euro breakup he mused about the alternative of a “mutation” of the existing monetary arrangement to a three-tier monetary union. He explained:

“The first step in this process would be for northern European countries to index all financial and real-economy contracts, as well as payments to and receipts from governments, to national inflation rates. This protects these countries’ residents from the effects of the ECB’s looser policy. Should inflation really kick up, however, the contracts could be redenominated in a new currency whose supply would be managed by a subsidiary of the stronger countries’ national central banks.

The parallel currency would exist only virtually, as a means to store wealth in countries with secure government finances and strong trade links with Germany. The euro would continue to be used as the basis for cash transactions. …

“Softening” the euro still might not be enough for countries like Greece, however. When external funding for these governments’ budget deficits eventually dries up, they could be made to issue IOUs to their domestic creditors. When these IOUs start to be traded, they could assume the role of a second parallel currency. But this currency would exist only as a means of transaction; the euro would remain as a store of value in the background.

Thus a three-tier euro zone would emerge. Countries like France, Italy and Spain would become the “core” countries, where the euro would be used both as a medium for transactions and a store of value. Germany, the Netherlands, Finland and its peers would constitute the “upper tier,” where the euro is a means of transaction but not a store of value. Countries such as Greece, Cyprus and Portugal would compose the “lower tier,” where the euro is a store of value but not a means of transaction.”

Matthew Boesler (Business Insider) elaborated further on Thomas Mayer’s idea of a parallel currency for Greece. Summarizing his approach he wrote that the Troika could decide on “a partial stop in financial assistance, with continuing support for debt service needs and the Greek banking sector but no further support for the financing of the government’s primary expenses.”

Where would the cash come from to cover the latter expenses? Boesler, citing Mayer:

“[A] plausible response of the government to the shortage of euro cash as a result of the end of financial transfers would be to issue debtor notes (IoUs) to its creditors, promising payment as soon as fresh euro cash would become available. As creditors lacking euro cash would have to use the IoUs to settle their own bills, these instruments would assume the role of a parallel currency (let’s call it Geuro).

The Geuro would probably quickly be used in most domestic transactions. For the purchase of essential imports, Geuros would have to be exchanged against euros, most likely at a hefty discount of 50% or more. Since an increasing number of domestic goods, services and wages would be paid in devalued Geuros, the export sector could reduce its prices in euro and regain competitiveness against foreign suppliers. …

Greece could formally remain in EMU, execute the exchange rate devaluation necessary to regain international competitiveness, and in the future decide for itself through issuance of Geuros, whether and over what time span it would want to return to a hard currency that is stable against the euro. It could eventually even return completely to the euro by repurchasing Geuros against euros.”

David Marsh, too, reflected about a parallel currency for Greece. In the event that talks with creditors break down, in his concept Greece would also remain part of the eurozone but with different arrangements for domestic and international transactions. He wrote:

“Greece would have to print its own currency, the new drachma (ND), which would be heavily depreciated. All domestic wages and prices would be fixed in ND, with the euro still in force for international payments. The government could initially peg the ND wherever it wished, maybe 10% below par with euro, but could then leave it to float lower. Very likely the new currency would settle 20 to 30% below the current imputed value of the Greek currency against the euro.”

The fixing of contracts and payments in a new currency with rapidly declining value is exactly what many Greeks fear. The mere announcement of such a policy would result in more cash withdrawals and capital flight driving the country ever faster into ruin.

But what if the state makes it quite clear from the beginning that

– no existing contracts would be touched;

– in reaction to a liquidity shortfall new currency could be issued by the government, but also by any other economic agent with public acceptance deciding whether it gets established or not;

– new currency which would be established beside the euro would be solely intended to transitorily fill the gap which the ECB left in retreating from its lender-of-last-resort function;

– its use, and that of the euro, would not be restricted to a special purpose such as government transactions, domestic sales or international trade;

– the exchange rate between the euro and any new currency would be negotiated freely in transactions;

– denomination could be chosen freely by the issuer – be it in euro or another currency or a precious metal;

– the circulation of new currency would be limited explicitly to the time of the shortfall in euro liquidity. Once economic prospects improve and the role of the ECB becomes less ambiguous it would cease;

– any kind of new currency beside the euro would be held and dealt in entirely voluntarily.

This is the concept of Notgeld (necessity money or emergency money) as it is known from history.

Emergency money

There is a long tradition of emergency money in times of crisis. However, as noted by Iliazd in the introduction to a remarkable Flickr Notgeld album of over 5,000 mostly German notes “Notgeld was not the norm but the exception in the history of currencies” making it a sought-after collector’s item.

Here are some extracts from the introduction to illustrate the nature of the instrument:

“Notgeld (emergency currency) was issued by cities, boroughs, even private companies while there was a shortage of official coins and bills. Nobody would pay in coins while their nominal value was less than the value of the metal. And when inflation went on, the state was just unable to print bills fast enough. Some companies couldn’t pay their workers because the Reichsbank just couldn’t provide enough bills. So they started to print their own money – they even asked the Reichsbank beforehand. As long as the Notgeld was accepted, no real harm was done and it just was a certificate of debt. Often it was even a more stable currency than real money, as sometimes the denomination was a certain amount of gold, dollars, corn, meat, etc.

It was not legal tender, so the only people who dealt in it were those that wanted to. It was very stable and debt free. To keep it flowing, sometimes it was set up to lose 2 or 3% of its value every month, which kept people from hoarding it.

There were several advantages to issuing Notgeld. First, it stabilized local government and local markets, so people could sell and buy what they needed and government services kept functioning. Second, it was a stabilizing influence on the real currency, which was still used. And third, it helped to concentrate the real currency at the government level, so they could import things not found locally.

It was a controlled complementary currency, so prices were set by whoever issued it. In effect, this created wide scale and orderly rationing.”

Reading this I was wondering what role a digital currency such as Bitcoin could play in such a case these days …

The introduction of emergency currency beside the euro would allow the Greek government to flexibly react to a liquidity shortage, mitigate its effects and resume negotiations with its creditors under less pressure. In contrast to concepts of a parallel currency emergency currency would be created where it is needed. The spreading to many issuers would reduce the risk of default. Different conditions and denominations would secure the attractiveness in different circumstances.

In analogy to an argument used by Martin Sandbu (Financial Times) Greece cannot make Notgeld legal tender beyond the payment it is used for. But an emergency currency would enable the government to economise on euros, leaving them for cases where Notgeld would not be accepted. These would include

– cases where emergency money is not accepted in domestic transactions;
– most international transactions;
– international debt payments.

Since living and making economic policy in a state of emergency is not desirable and promoting economic growth has highest priority to end it as soon as possible, default on existing debt and negotiation of debt restructuring is a real option. As Michael Pettis stressed, trade and investment flow to countries with good future prospects, and not to countries with good track records. Once growth prospects improve, with among other things a manageable debt burden, “foreign businesses and investors will fall over each other” to regain the market regardless of a country’s debt repayment history. He emphasized: “This is one of those things about which the historical track record is quite unambiguous.”

In another article Pettis further elaborated on the point:

„Debt can be thought of as a moral obligation when a loan is extended from one individual to another, especially if there is no interest on the loan. But loans to businesses or to sovereign entities are business transactions, and they should be managed as such. The only moral obligation in restructuring sovereign debt, it seems to me, is for policymakers to fulfill their political responsibilities to do what is in the best interests of their citizens and to participate in a responsible way in the global community. The debt restructuring process is, in other words, morally neutral.”


There must be innumerable disadvantages of this proposal to allow for emergency currency and I am looking forward to your comments on it. Surely, at first glance, the idea seems crazy. With several currencies in circulation economic processes risk to become more cumbersome, less efficient and less transparent. But, as Michael Pettis asked in a different context: Compared to what? The Greek economy is already in disastrous shape, its debt burden is choking any long-term economic recovery, it can never grow its way out of its debt no matter how radical and forceful the reforms, and a liquidity shortfall may put an abrupt end to any remaining illusion of the benefits of EMU membership.

Examples of parallel currencies in and outside the euro area have shown that they can function remarkably well on a local level, promoting entrepreneurial initiative and stimulating economic activity. For Greece, fending off the immediate dangers, regaining control over its economic – and to some extent within existing restraints – monetary situation as prerequisite for long-term recovery should take precedence over all other political considerations. Maybe a crazy idea is what is needed now.

Perspectives on the Greek challenge

These days, there is a flood of articles and comments of varying quality and importance on Greece and the eurozone. With the following quotes I would like to draw attention to a small selection of contributions which may be relevant beyond the day.


Joseph E. Stiglitz: A Greek Morality Tale

Both supporters and opponents of the plans of the Greek government cite moral arguments why Greece should, or should not, have its way in the current situation. Opponents point to the risk of moral hazard. As Joseph Stiglitz put it: “There is a fear that if Greece is allowed to restructure its debt, it will simply get itself into trouble again, as will others.”

Joseph Stiglitz tells another morality tale as the following excerpts from his article show. Furthermore, he reminds us that the current crisis is not a Greek problem but deeply rooted in the structure of the eurozone:

“When the euro crisis began a half-decade ago, Keynesian economists predicted that the austerity that was being imposed on Greece and the other crisis countries would fail. It would stifle growth and increase unemployment – and even fail to decrease the debt-to-GDP ratio. Others – in the European Commission, the European Central Bank, and a few universities – talked of expansionary contractions. But even the International Monetary Fund argued that contractions, such as cutbacks in government spending, were just that – contractionary.”


“[L]et us be clear: Greece could be blamed for its troubles if it were the only country where the troika’s medicine failed miserably. But Spain had a surplus and a low debt ratio before the crisis, and it, too, is in depression. What is needed is not structural reform within Greece and Spain so much as structural reform of the eurozone’s design and a fundamental rethinking of the policy frameworks that have resulted in the monetary union’s spectacularly bad performance.”


The Greek example points to a fundamental problem. It reminds us “how badly the world needs a debt-restructuring framework. Excessive debt caused not only the 2008 crisis, but also the East Asia crisis in the 1990s and the Latin American crisis in the 1980s. It continues to cause untold suffering in the US, where millions of homeowners have lost their homes, and is now threatening millions more in Poland and elsewhere who took out loans in Swiss francs.
Given the amount of distress brought about by excessive debt, one might well ask why individuals and countries have repeatedly put themselves into this situation. After all, such debts are contracts – that is, voluntary agreements – so creditors are just as responsible for them as debtors. In fact, creditors arguably are more responsible: typically, they are sophisticated financial institutions, whereas borrowers frequently are far less attuned to market vicissitudes and the risks associated with different contractual arrangements.”


“So it is not debt restructuring, but its absence, that is “immoral.” There is nothing particularly special about the dilemmas that Greece faces today; many countries have been in the same position. What makes Greece’s problems more difficult to address is the structure of the eurozone: monetary union implies that member states cannot devalue their way out of trouble, yet the modicum of European solidarity that must accompany this loss of policy flexibility simply is not there.”


Silvia Merler: Who’s (still) exposed to Greece?

When Syriza won elections on a pledge of ending austerity policies and seeking debt relief one immediate question was who is still exposed to Greece. Silvia Merler provided statistics which indicate that on the creditor side the situation is far less dramatic than a few years ago. She observed:

“Since the start of the crisis, the structure of Greek debt has changed considerably (almost 80 percent of government financial liabilities are now accounted for by loans, against slightly less than 20 percent back in 2008). At the same time, the weight of public creditors has increased among the creditors of the government. … At the end of 2013, debt due to official creditors amounted to 216 billion of loans (IMF/EU loans) and 38 billion of securities (under SMP). This means that, at the end of 2013, official creditors accounted for about 94 percent of the total loans due to non-residents and 89 percent of the total securities held by non residents.”


“The data show, however, that since 2012 (when the ECB introduced the OMT programme) private investors have been timidly and slowly coming back to Greece. While exposures of euro area banks are still at very low levels compared to the pre-crisis period, it is tempting to interpret this as a first trace of normalisation and a resumption in confidence, which the present political turmoil risks reverting.”

ECB interference and the game of a “bankrupt country”

Frances Coppola: What on earth is the ECB up to?

As the Greek government is in danger to run out of money soon, all eyes focus on the role of the European Central Bank (ECB). What on earth is the ECB up to? asked Frances Coppola as the central bank lifted the waiver under which it had been prepared to accept Greek sovereign bonds as collateral for liquidity. Referring to the timing of the decision Frances in a passionate rant questioned the legitimacy of its interference. Furthermore, she pointed to the fact that the ECB has pursued this strategy before:

“The ECB is acting far beyond its mandate in seeking to influence negotiations between Eurozone member states regarding the terms and conditions under which member states lend to their distressed partners. It has no business interfering in fiscal policy: if the Greek government decides to run 1.5% fiscal surpluses instead of 4.5%, hike minimum wages and create lots of government jobs, it is none of the ECB’s business. The ECB’s monetary policy failures are legion: it should put its own house in order, rather than interfering with the conduct of fiscal policy. And worse, its persistent interference in fiscal policy is a clear conflict of interest, as the Advocate General of the European Court of Justice noted in relation to the OMT programme. It should not be a member of the Troika at all, and certainly should not use changes in fiscal policy by a democratically-elected sovereign government – even one that has inherited an economy in tatters with a massive debt burden – as justification for limiting liquidity to that country’s banking system. Monetary policy should never be used to serve fiscal or political ends. Not ever.”


“Over 6 months ago, Varoufakis predicted that the ECB would attempt to pull funding from the Greek banks. …
[P]ulling ELA from Greek banks would cause their sudden disorderly collapse. The ECB has used this trick before: it threatened to pull ELA from Irish banks in 2010, and it actually pulled ELA from Cyprus’s Laiki Bank and the Bank of Cyprus, forcing immediate closure and restructuring. This second piece of brinkmanship resulted in the worst bank bailout decision in the history of the planet, which was (fortunately) subsequently overturned by the Cypriot legislature. Undermining deposit insurance is almost criminally insane.”


As the Greek finance minister Yanis Varoufakis has a background as an expert in game theory many observers were musing about the strategy behind his decisions. Frances Coppola came upon a very interesting approach which explains how in a game called “coercive deficiency” weakening Greece’s position could actually strengthen its hand. [The footnotes in the following quote all refer to a piece by Jacques Sapir which you might be interested to check.]

“In this strategic game, it is clear that Greece has deliberately chosen the strategy qualified by Thomas Schelling, one of the founders of game theory, but also of nuclear dissuasion, as «coercive deficiency»[5]. In fact, this term of «coercive deficiency» was imagined by L. Wilmerding in 1943 in order to describe a situation where agencies enter into expenses without prior financing, knowing that morally the government will not be able to refuse funding them [6]. Schelling’s contribution consists in showing that this situation can be generalized and that a situation of weakness can reveal itself to be an instrument of coercion upon others. He also showed how it can be rational for an actor knowing himself to be in a position of weakness from the start, to increase his weakness in order to use it in negotiation. Reversing Jack London, one can speak in this instance of a “strength of the weak.” [7]. It is in this context that we must understand the renunciation by the Greek government of the last slice of aid promised by the so-called «Troïka, » amounting to 7 billion euros. Of course, having rejected the legitimacy of said “Troïka, » it could not logically accept to take advantage of it. But, in a more subtle way, this gesture is putting Greece voluntarily at the edge of the abyss and demonstrates all at once its resolve to go the bitter end (like Cortez burning his ships before moving up to Mexico) and to increase the pressure on Germany.”

Central bank rules versus discretion

Karl Whelan: What’s Going On with Greece and the ECB?

The role of the ECB is also the topic of this article by Karl Whelan. He discussed the extent to which ECB decisions are rule-bound:

“One of the key uncertainties surrounding the situation in Greece is the relationship between the Greek banks and the ECB. Lots of press coverage is suggesting the ECB has a set of well-established rules that mean it will not be able to lend to Greek banks in March unless the government negotiates a new EU-IMF program to replace the one expiring at the end of this month. …
As a general matter, the idea that the ECB is considering pulling funding from the Greek banks seems to be true. But, as is often the case when the world’s press attempts to understand the ECB, the reports get most of the details wrong.”


“… the ECB has almost complete discretion over which banks it lends to. I have written about the ECB’s Risk Control Framework before and it’s been rolled out regularly in the years since I wrote that post. The bottom line is that the ECB can single out specific institutions and decide to not lend to them for pretty much whatever “risk-related” reason they feel like putting forward. Still, this approach, if taken, isn’t based on any hard and fast rules.”


“… the idea of “junk-rated bonds are only eligible if a country is in a program” being part of “the ECB’s rules” is an over-statement. In truth, the ECB makes up these rules as it goes along and the “in again, out again” routine with Greek government bond eligibility is a long-standing one at this point.”


“… Greek banks were using at most €8 billion in Greek government debt in December as collateral for loans from the Eurosystem. Set against the total loans of €56 billion owed to the Eurosystem this is fairly small beer. (Factoring in haircuts, its share in collateral would be even less than this comparison suggests).
So, on its own, the eligibility of Greek government bonds is just not that big a deal.”


“The ECB is pretty clearly playing from its tried and tested playbook in their current stand-off with the Greek government. Governing Council members know they can cut off lots of credit from the Greek banks in March and many of them are happy to tell the world they are thinking about doing this. As a result, they hope to get Greece’s new government to sign a new deal with the EU and IMF. But don’t believe for a minute that this is a technocratic thing to do with “the ECB having to follow its rules.””


“I fully expect the ECB-as-heavy-hearted-technocrat angle to dominate press coverage of this story this month. That’s a pity because the “ECB in politicised mission creep while helping trigger a bank run” story is more interesting and closer to the truth.”

Lessons from history

Michael Pettis: Syriza and the French indemnity of 1871-73

In a knowledgeable and highly readable article which has too many important points to do it justice here Michael Pettis put the current conflict in Europe into historical perspective. Here are some snippets:

“European nationalists have successfully convinced us, against all logic, that the European crisis is a conflict among nations, and not among economic sectors. …
This is absurd. The European debt crisis is not a conflict among nations. All economic systems— and certainly an entity as large and diverse as Europe— generate volatility whose balance sheet impacts are mediated through different political and economic institutions, among which usually are domestic monetary policy and the currency regime. With the creation of the euro as the common currency among a group of European countries, monetary policy and the currency regime could no longer play their traditional roles in absorbing economic volatility. As a result, for much of the euro’s first decade, a series of deep imbalances developed among various sectors of the European economy. Because Europe’s existing economic and political institutions had largely evolved around the national sovereignty of individual countries, and also because the inflation and monetary histories of individual countries varied tremendously before the creation of the euro, it was probably almost inevitable that these imbalances would manifest themselves in the form of trade and capital flow imbalances between countries.”


“Resolving a debt crisis involves nothing more than assigning the losses. In the current crisis these costs have to be assigned to different economic sectors within Europe, but to the extent that the assignation of costs can be characterized as exercises in national cost allocation, it is easy to turn an economic conflict into a national conflict.”


“Most currency and sovereign debt crises in modern history ultimately represent a conflict over how the costs are to be assigned among two different groups. On the one hand are creditors, owners of real estate and other assets, and the businesses who benefit from the existing currency distortions. One the other hand are workers who pay in the form of low wages and unemployment and, eventually, middle class household savers and taxpayers who pay in the form of a gradual erosion of their income or of the value of their savings. Historically during currency and sovereign debt crises political parties have come to represent one or the other of these groups, and whether they are of the left or the right, they are able to capture the allegiance of these groups.
Except for Greece, in Europe the main political parties on both sides of the political spectrum have until now chosen to maintain the value of the currency and protect the interests of the creditors.”


“By early 1871, the French army was roundly defeated by Prussia, which during that time had unified the various German states as the German Empire under the Prussian king … [One] consequence was the French indemnity. As part of the privilege of conquest and as a condition for ending the occupation of much of northern France, Berlin demanded war reparation payments originally proposed at 1 billion gold francs but which eventually grew to an astonishing 5 billion, at least in part because of an explicit decision by Berlin to impose a high enough burden permanently to cripple any possible French economic recovery. …
[But] France was able to raise the money very quickly, mostly in the form of two domestic bond issues in 1871 and 1872, which were heavily over-subscribed …”


“One important point is to distinguish between financial crises that occur within a globalization cycle and those that end a globalization cycle. Whereas the latter are often devastating and mark the end for many years of economic growth, the former — like the 1994 Tequila crisis or the 1997 Asian crisis, or even the 1866 Overend Gurney crisis — may seem overwhelming at first, but markets always recover far more quickly than most participants expect. When markets are very liquid, and in their leveraging-up stage, they can absorb large debt obligations easily, and because they can even turn these obligations into “money”, they almost seem to be self-financing.
The 1858-73 period was one such “globalization period”, with typical “globalization” characteristics: explosive growth in high-tech communications and transportation (mainly railways), soaring domestic stock and real estate markets, booming international trade, and a surge in outflows of capital from the UK, France, the Netherlands and other parts of Europe to the United States, Latin America, the Far East, the Ottoman Empire, and other financial “frontiers”.


“From an “asset-side” analysis, as I discuss in my January 21 blog entry, the transfer of capital over three years from France to Germany equal to more than 20% of either country’s annual GDP would have had very predictable impacts — they should have been very negative for France, as Berlin expected, and very positive for Germany. In fact the actual results were very different. This is because there are monetary and economic conditions under which liability structure matters much more, and conditions under which it matters much less. Economists and the policymakers they advise are too quick to ignore these differences, perhaps because there is not as well-formulated an understanding of balance sheets in economics theory as in finance theory, so that when someone like Yanis Varoufakis proposes that there are ways in which partial debt forgiveness increases overall economic value, instead of merely creating moral hazard, worried economists often recoil in horror, while finance or bankruptcy specialists (and an awful lot of hedge fund managers) shrug their shoulders at such an obvious statement.”


“What does all of this have to do with Syriza? A few weeks ago I was discussing with a group of my Peking University students Charles Kindleberger’s idea of a “displacement”, and I proposed, as does Kindleberger, that the 1871-73 French indemnity is an especially useful example of a displacement from which we can learn a great deal about how financial crises can be generated.(4) It then occurred to me that the French reparations and their impact on Europe could also tell us a great deal about the euro crisis and, more specifically, why by distorting the savings rate wage policies in Germany in the first half of the last decade would have led almost inexorably to the balance of payments distortions that may eventually wreck the euro.”


“[T]here are three important things to remember:
1. There is an enormous economic cost, not to mention social and perhaps political, to any delay. I worry about the terrifyingly low level of sophistication among policymakers and the economists who advise them when it comes to understanding balance sheet dynamics and debt restructuring. Greece’s debt overhang imposes rising financial distress costs and increasingly deep distortions in the institutional structure of the economy over time, and the longer it takes to resolve, the greater the cost. …
2. From what I read, much of the focus of the restructuring will be aimed at determining an acceptable and manageable debt-servicing cashflow for Greece. There is a mistaken belief that this is the only “real” variable that matters, and the rest is cosmetics. I don’t agree. Greece’s nominal debt structure will not just affect the debt-servicing cashflows but will also determine future behavior of economic agents. …
3. In fact the overall restructuring must be designed so that the interests of Greece, the producers who create Greek GDP, and the creditors are correctly aligned. To date sovereign debt restructurings have almost never included the instruments that reflect the instruments in corporate debt restructurings that accomplish this alignment of interests …
Yanis Varoufakis should really take the lead in designing an entirely new form of sovereign debt restructuring, not just for Greece but for the many countries, in Europe and elsewhere, that will soon follow it into default.”

The derivatives issue

Mark Melin: “Confrontational” Greece Negotiations Suddenly Turn Into Polite Tea Party

There is one aspect which in contrast to earlier stages of the euro crisis, this time seems to play a minor role in public debates. This is what Mark Melin called the derivatives issue. But, possibly, this has been resolved behind the scenes already. Reviewing a Goldman Sachs research analysis Mark Melin argued that in agreeing to not seek to reduce the total amount of their debt through forgiveness Greece has given up “its most important bargaining chip”. He wrote:

“This last issue is key, because the derivatives that underlie the financial system are said to be significantly exposed to sovereign debt default and related interest rates. Had Greece sought debt forgiveness, it might have created a daisy chain reaction in many of the large bank unregulated derivatives positions. Such an event is a national security concern …

The Goldman Sachs report did not address the derivatives issue, as the bank is among the largest issuer of such “insurance” contracts.
One of the key components discussed in the Goldman Sachs report is the potential for a “Grexit,” which Goldman says could cause significant market volatility, labeling the issue “systemic” as magnitude was considered. “The intensity and persistence of such volatility would depend on the process by which Grexit occurred, and on the nature of the policy and political response to it in other Euro area countries.”

What the report didn’t say is that if a Grexit were to occur, it would probably occur as relations are strained and a demand for debt forgiveness was the central issue. In other words, a Grexit correlation to a sovereign bond default might be a high probability relationship. The Greeks, however, are unlikely to trigger the bank’s derivatives exposure. The cost would simply be too high.”

A conclusion?

In particular with respect to the last aspect I would like to conclude modifying an earlier quote from Karl Whelan:

Don’t believe for a minute that this is a European policy thing to do with Greece, its economy or its people.

Black Swan, Dragon King, Greek Tragedy – Lessons from a “Diplomatic Debate”

In his Ted Talk Dragon King beats Black Swan in June 2013 Didier Sornette contrasted his ideas of market predictability to Nassim Taleb’s concept of a Black Swan. As Sornette explained a black swan is a rare bird. Seeing a black swan shatters all beliefs that swans should be white. The Black Swan stands for the idea of unpredictability and extreme events that are “fundamentally unknowable”. Sornette compared this idea with his concept of a Dragon King which is “exactly the opposite”. According to his view, most extreme events are actually knowable and – at least to a certain extent – predictable.

In May 2014, there was a very stimulating ETH-sponsored debate between Nassim Taleb and Didier Sornette which threw further light on their “Diametrically Opposite Approaches to Risk & Predictability”, so the title of the meeting. The following video is an edited version of what Nassim Taleb called a “diplomatic debate”. To him this is a conversation in which one looks for synthesis as opposed to one in which one is trying to win an argument by all means. This is surely benefitting the audience who, if they had not read their books, may know Didier Sornette and Nassim Taleb mainly from their highly technical scientific papers here and here.

For an outside observer it is hard to take sides after these 45 minutes. To me, there seems to be no “right” or “wrong”. There are valid arguments on either side and on second sight Taleb’s Black Swan turns out to be one of several possible crisis scenarios in Sornette’s framework.

Nassim Taleb’s focus is on risk management of exposures. He starts with the example of a china cup which is fragile because “it doesn’t like volatility and has very specific attributes.” (0:43) On the other side, there are other things with other attributes which like volatility. The same holds in risk management. Knowledge about these attributes allows to adjust exposures respectively and benefit from volatility without identifying and predicting a concrete event.

Taleb draws attention to three mistakes which in his view people make in managing risk:

(1) They study random variables as sources of risk instead of exposures (1:06). He argues that very often risk, or the source of risk, is extremely hard to compute. He can avoid this wasting of time, as he calls it, by changing his exposure instead. (1:20)

(2) People tend to adjust to the worst past. (This is the example of the high-water mark at 1:51) But, as Taleb argues, if you look at natural things, they don’t adjust in the same way. They adjust to something higher and “overcompensate”. But the brain doesn’t. This explains why in his view when people study risk they are not as good as when they act based on their perception of risk.

(3) People neglect that the response of their exposures to a source of risk is nonlinear. In Taleb’s concept, exposure to the source of risk may be concave or convex, and concavity – an accelerated harm or negative response to risk – and fragility are related. A single item may be fragile. “If you’re fragile than you’re necessarily concave to the source of risk.” (3:35) Take again the china cup. There are more downsides than upsides from earthquakes in this case. In contrast, Taleb’s exposure is symmetric.

Didier Sornette’s approach is indeed “diametrically opposite” to this concept. While Nassim Taleb accepts the world’s inherent uncertainty, and abstains from trying to predict the course of random events, Didier Sornette and his Financial Crisis Observatory in a sense are searching for “patterns”. According to Sornette extreme events such as the French revolution in 1789 or the “Spanish” worldwide flu of 1918, but also the dotcom crash in 2000 and the financial crisis in 2008, go through dynamical processes that make them knowable and to some degree predictable before they occur (6:20).

Focusing on financial time series and studying the distribution of peak-to-valley losses Sornette shows that a large part of these losses can be represented by a power law (6:39). However, some of them, which are associated with great crashes in the past, are outliers. They occur much more frequently than predicted by the law. These are the Dragon Kings.

As Sornette wrote in his book Why Stock Markets Crash: “Large financial crashes … form a class of their own that can be seen from their statistical signatures. … They are special and thus require a special explanation, a specific model, a theory of their own.” (p.xvi)

In the debate, Sornette then goes on arguing how these extreme events result from a progressive maturation towards an instability or bifurcation. He takes water levels at different temperatures as an example (7:53). The fact that at the boiling point the nature of the water changes can be inferred from the past although “macroscopic linear extrapolation” is no longer possible.

Note in this context what Nassim Taleb wrote in his textbook on Probability and Risk in the Real World (p. 13): “The risk of breaking of the coffee cup is not necessarily in the past time series of the variable; in fact surviving objects have to have had a “rosy” past.” This may hold for the coffee cup, but not for water. In Didier Sornette’s example, the past of the observed variable was “rosy”, too. Nevertheless, he argues that it is possible to draw conclusions from the past dynamics of the water about its entirely different behaviour in the future.

Sornette considers financial market crashes as the result of the collective behaviour of herding agents that ends up destabilizing the system (“a single molecule does not boil at 100°”). But, he continues that there is good news: From the theory of bifurcations and dynamical systems he has learned about the Fundamental Reduction Theorem. It says that most of the time, the system is too complex to predict its behaviour. But, close to bifurcation there is a window of visibility (9:10).

Sornette continues explaining how „generally, close to a regime transition, a system bifurcates through the variation of a single (or a few) effective “control” parameter”. This brings him to two questions:

Can predictability be implemented in practice? Can the process be influenced?

As an example he presents the activities of the Financial Crisis Observatory developed at ETH Zurich since 2008. There are two hypotheses:

Hypothesis 1: Financial (and other) bubbles can be diagnosed in real-time before they end.

Hypothesis 2: The termination of financial (and other) bubbles can be bracketed using probabilistic forecasts, with a reliability better than chance (which remains to be quantified).

Passionately, Sornette states that never again will we “go through the process of these extremely damaging crises where the policymakers, analysts and so on conclude that … this was not knowable in advance.

Furthermore, this type of knowledge should empower the researcher to go to the next stage which is control. “Of course the control system is not of the scale of the full financial market but … in some circumstances, when we understand this system shows this power distribution of events with a Dragon King, by very tiny perturbations at the right moment we can actually control and slay this Dragon King.

Sornette finishes his presentation by summarizing his view in a kind of predictability diagram where he distinguishes two dimensions (13:25). One is heterogeneity or diversity of the different elements in the system and the other is the level of coupling or interaction. “By classifying a system in a given regime, we can assert its degree of predictability.” In this framework, non-predictability is part of a larger picture. Sornette concedes that there are Black Swans, but most crises are Dragon Kings:

This Financial Crisis Observatory that we have developed, for me was really a reaction to the disgust that developed from the often heard statement that the financial crisis of 2008 was a big surprise, was a Black Swan. It was no Black Swan, it was clearly visible – not in detail. But it was clearly visible that something was going to happen.

And, according to his findings it is about to happen again (see also at the end of this article the extract of an interview Sornette gave to Finanz und Wirtschaft in September 2013). Right now, a crisis has been looming for many years and once the bubble bursts nobody can pretend that this was not knowable in advance. As Sornette said: Not the details, but the broad picture. And we feel that he is right in that policymakers and analysts foreseeably will come up exactly with the Black Swan argument that this is coming as a surprise – and we will know simply from watching from outside that this cannot be true. Whether the dynamics can be captured in mathematical detail early enough to prevent the bubble from bursting is another matter. But it is encouraging to see that in Zurich efforts are made in this direction.

What has the Greek tragedy mentioned in the title to do with all this? It is not the form of theatre I had in mind, but the drama which is currently unfolding in the Eurozone. Both Taleb and Sornette stress that bubbles and crises are part of our lives. They will happen again and again. On January 25, Greece could become a trigger – as could any other minor or major event before and after. Then again analysts and policymakers will tell us that this is a Black Swan.

Do not believe them. They could have known.


The following is a short extract from a German-language interview with Didier Sornette by Gregor Mast und Mark Dittli, Finanz und Wirtschaft, September 19 2013:

„Die Notenbanken pumpen neue Blasen auf“

Herr Sornette, fünf Jahre sind seit dem Zusammenbruch von Lehman Brothers vergangen. Ist das globale Finanzsystem heute sicherer als 2007?
Nein, im Gegenteil. Die Situation ist schlimmer als zuvor. Die zehn bis fünfzehn grössten Banken sind heute noch grösser und von noch höherer systemischer Wichtigkeit als vor fünf Jahren. Sie bilden als sogenannte Superspreader das Zentrum des globalen Finanznetzwerks. All die falschen Anreizsysteme innerhalb der Banken sind intakt, da wurde nichts geändert. Das wissen die Banker, die Regulatoren und die Notenbanker ganz genau. Alles, was in der Zwischenzeit getan wurde, all die Stresstests, die Massnahmen der Notenbanken, diente bloss dazu, das Vertrauen ins System wieder herzustellen. Die grundsätzlichen Probleme wurden nicht angepackt.
Wir tanzen eine Art Tango aus ¬Manie und Crash. Und die Notenbanken reagieren auf jeden Crash damit, dass sie eine neue Blase aufpumpen.

Tun sie das auch jetzt wieder?
Ja und nein. Unbestritten ist: Wir sehen heute eine enorme Blase im Bondmarkt, im gesamten Kreditvolumen. Mit ihren riesigen Bilanzen führen die Notenbanken ein einzigartiges Experiment durch. Generell kann gesagt werden, dass eine Unmenge an Geld gegenwärtig nach Anlagemöglichkeiten sucht. Wir identifizieren am Financial Crisis Observatory an der ETH heute eine ganze Reihe blasenähnlicher Übertreibungen in verschiedenen Märkten. Es blubbert überall. Das Finanzsystem ist viel fragiler als früher.

Sie führen die vierjährige Hausse an den Börsen auf die Politik des Fed zurück?
Wir sehen auf jeden Fall eine hohe Korrelation zwischen dem Bilanzvolumen des Fed und dem amerikanischen Aktienmarkt. Jedes Mal, wenn ein Quantitative-Easing-Programm startete, stiegen die Kurse. Und jedes Mal, wenn eines stoppte, kam es zu einer Korrektur.

Wie wird das alles dereinst enden?
Die Frage ist furchteinflössend. Wir wissen, dass diese Geldpolitik nur kurzzeitig den Schmerz lindert, die grundsätz¬lichen Probleme aber nicht löst. In den USA haben wir einen dreissigjährigen kreditgetriebenen Boom gesehen. In Europa, um ein anderes Beispiel zu -nennen, haben wir mit dem Euro ein ¬unfassbares Monster geschaffen, eine politische Kreatur, ohne jeden ökonomischen Verstand. Das kann die EZB nicht ewig überdecken.“
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Interconnectedness, uncertainty and innovation – Brian Arthur on economic complexity

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Banks and Biology – the Super-spreader Analogy

Between the years

Where I live, the time between Christmas and New Year – or “between the years” as we call it – is a quiet time. Business has slowed down in many areas and the frantic activity of Christmas preparations is over. The old year is still ruling but there is not much left to do and although once in a while thoughts are wandering ahead to new plans and challenges we are not willing to face them yet. This is a time to lean back and enjoy the lights and warmth sheltered from a grey and hostile environment outside, the company of family and friends, the purring cat, films and books, longer than usual Twitter conversations and a stroll through the vasts of the internet.

From the latter, there is a small choice of pieces which I would like to share with you.

Making Manuscripts

Have you ever had the opportunity to look at some of the precious ancient books produced by monks in the Middle Ages? There is a wonderful video from the Getty Museum channel which shows how they were made:

“An illuminated manuscript is a book written and decorated completely by hand. Illuminated manuscripts were among the most precious objects produced in the Middle Ages and the early Renaissance, primarily in monasteries and courts. Society’s rulers–emperors, kings, dukes, cardinals, and bishops–commissioned the most splendid manuscripts.”

How Ballerinas Are Preparing Their Pointe Shoes

Did you watch a Christmas ballet this year admiring the seeming weightlessness of the ballerinas? And did you possibly think to yourself what dancers are doing to their feet when going on pointe? In a fascinating article, Olga Khazan from The Atlantic is presenting YouTube videos of ballet dancers preparing their pointe shoes. She writes:

“Don’t get me wrong, I like the actual ballet well enough. But there’s something so uniquely soothing and satisfying about seeing these women (it’s mostly women—male dancers are usually too heavy to go on pointe) ready the tools of their trade.

There’s the slipping of the original, light-pink shoe out of its bag, and then the hours spent scraping, ripping, crushing, sewing, and burning (!!), only to end up with a shoe that looks identical to the layman but is uniquely tailored to the ballerina.”

In one video from the Australian Ballet, for example, dancer Jessica Fyfe explains how she has six to eight pairs of shoes going at once, including “a pair that’s good for jumping in, a pair that’s stage-perfect…“

In another video, Pennsylvania Ballet Principal Dancer Arantxa Ochoa says she goes through 60 pairs per season. To make them last slightly longer, she glues the tips. Like many other dancers, she also cuts off the material around the toes to keep herself from slipping.

Citing Olga Khazan again: “It’s almost like the dance’s most distinctive qualities—exterior perfection, inner struggle, insane physicality—get concentrated in the shoes. Even early retirement: After one or two stage performances, the shoes begin to “die.””

See for yourself! Here is the article and this is one of the videos:

Astronaut’s-Eye View of NASA’s Orion Spacecraft Re-entry

Extraordinary things happened in the last weeks of the year. Did you find the time among deadlines at work and Christmas preparations to follow NASA’s Orion project in December? There is an awesome video presenting the last 10 minutes of the Orion’s test flight which gives a glance of what an astronaut could see from a spacecraft while rushing down through our planet’s atmosphere:

“The video begins 10 minutes before Orion’s 11:29 a.m. EST splashdown in the Pacific Ocean, just as the spacecraft was beginning to experience Earth’s atmosphere. Peak heating from the friction caused by the atmosphere rubbing against Orion’s heat shield comes less than two minutes later, and the footage shows the plasma created by the interaction change from white to yellow to lavender to magenta as the temperature increases. The video goes on to show the deployment of Orion’s parachutes and the final splash as it touches down.”

Here you may see how the spacecraft was brought home afterwards. I liked the photo showing how it almost vanished in this huge ship.

Ambition the film

Another even more exciting project was Rosetta, the mission of the European Space Agency (ESA). Tomek Bagiński made a short film to advertise the Rosetta project. The film, titled “Ambition”, makes clear, that “it is the essence of what it means to be human, to attempt difficult things, to reach for seemingly impossible goals, to learn, adapt and evolve.

And at the heart of this film is Rosetta, ESA’s real mission to rendezvous with, escort and land on a comet. A mission that began as a dream, but that after decades of planning, construction and flight through the Solar System, has arrived at its goal.

Its aim? To unlock the secrets hidden within the icy treasure chest for 4.6 billion years. To study its make-up and its history. To search for clues as to our own origins.

From 100 km distance, to 50, 30 and then, defying all expectations, to just 10 km, Rosetta continues to captivate and intrigue with every image and every data packet returned.

It will rewrite the textbooks of cometary science.

But there is more, an even greater challenge, another ambitious first: to land on the comet.

The stage is set. The date: 12 November 2014.”

Read more

This is the film:

There is even a Making Of:

The making of ‘Ambition’

“The making of the short film Ambition, a collaboration between Platige Image and ESA. Directed by Tomek Bagiński and starring Aidan Gillen and Aisling Franciosi, Ambition was shot on location in Iceland, produced in Poland, and screened on 24 October 2014 during the British Film Institute’s celebration of Sci-Fi: Days of Fear and Wonder, at the Southbank, London.”

I enjoyed the film, but also thought about what Lukasz Sobisz (Simulation TD, Platiga Image) said in the Making Of:

“The actual campaign idea is certainly well targeted. But, shooting myself in the foot a bit, I’m very surprised that you need something like this at all now. Mankind sends a probe into space to catch a comet and land on it. And we need a great director, film and actors to convince people this is interesting.”

209 Seconds That Will Make You Question Your Entire Existence

The following is a nice video about the observable universe and your place in it. Unfortunately, I did not manage to embed it without the advertisement. Don’t get irritated. Simply klick, it’s very much worth watching:

A Year in the Life of Ise Shrine

From the silence in space to the silence on Earth: In a series of stunning images photographer Nakano Haruo documented the beauty of the four seasons at the Ise shrine, one of Japan’s most important sacred spaces. He writes:

“In Japan, it is traditional to begin the New Year by visiting a shrine to pray for good fortune in the 12 months to come. Ise Shrine will be a particularly popular choice this year. What better way to mark the New Year than by walking along the gravel paths leading to the ancient-but-always-new shrine at Ise?

I grew up in Ise, where my family ran a small business providing fish for the ceremonial offerings at the shrine. Growing up near the shrine, I got to know at close hand the many faces of the sacred precincts throughout the year. In spring, I used to follow the mejiro (Japanese white-eye) birds that played in the branches of the cherry trees; in summer, I could sense the trees and plants luxuriating in a sudden evening downpour; in autumn, I would enjoy the light streaming through the foliage; and in winter, I would occasionally wake to the wonderful surprise of a rare covering of snow. The sacred grounds of the shrine were home to more pleasures than I could count.”

Watch the photos here

In addition, you may like this video which gives a vivid, more worldly impression of the shrine during New Year visits:

Xmas Unwrapped by Toby Smith and Unknown Fields

Christmas has many facets. Beckett Mufson describes in the creatorsproject‘s blog how Holiday Doc Unwraps the Less-Than-Festive Factories Behind Christmas.

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See the video which explores those factories where holiday baubles are made:

Toby Smith explains:

“In August I travelled East with the Unknown Fields Division, to Vietnam, China and beyond. We traced the supply chain of the world’s consumer products across the South China Sea down cargo routes and inland to their production.

Yiwu in China is not only home to the world’s largest wholesale commodity market but also many of the “Just in Time” factories that produce seasonal or trending products. Christmas consumables are produced in summer ready for wholesale, packaging and shipping to principally western markets….”

How Cats See Christmas…

Christmas can be a challenging time, in particular for pet owners. Under the fresh impression of this year’s efforts to defend tree and decorations you may enjoy the following attempt to bridge the culture gap between you and your cat:

If this doesn’t help you may find many Christmas Greetings on the internet to cheer you up. The following one is starting with a quote from Shakespeare’s Hamlet, Act I, Scene 1:

Epic Chuck Norris Greetings – Merry Christmas with epic split

There is more:

From Brown Bag Films comes

Granny O’Grimm’s Christmas Greeting

Space Station Crew Members Offer Christmas Greetings to the World

“Aboard the International Space Station, Expedition 42 Commander Barry Wilmore and Flight Engineer Terry Virts of NASA offered their thoughts and best wishes to the world for the Christmas holiday during downlink messages from the orbital complex on Dec. 17. Wilmore has been aboard the research lab since late September and will remain in orbit until mid-March 2015. Virts arrived at the station in late November and will stay until mid-May 2015.”

And German football players, too, send their greetings:

FC Bayern wishes you a merry Christmas

Furthermore, there are the songs. Like this one:

Eva Celia – Have Yourself A Merry Little Christmas @ Mostly Jazz 21/12/13 [HD]

There is so much more. Maybe, you find time “between the years” to enjoy some of this admittedly haphazard selection. I’m sending season’s greetings to all of you and wish you peaceful days and a merry Christmas.


Tankan Japan

The Bank of Japan just published the latest results of its TANKAN survey which observers usually take as an indicator of the state of the Japanese economy and as signal in which direction future monetary policy may go. Here is some background information.

Read more…

Foreign Banks in Japan

In 2014, the International Bankers Association of Japan (IBA Japan) celebrates its 30th anniversary. For thirty years IBA Japan has represented the international banking community in Japan. Starting with 12 founding members in 1984 there are now just under 60 banking members from 22 countries and over 25 associate member firms.

In a speech at a meeting commemorating the anniversary, Haruhiko Kuroda, Governor of the Bank of Japan, mentioned the significant role foreign financial institutions played in Japan’s economy. However, relations between the banks and their host country were never free of tensions and compared to other world financial centres their influence is smaller than many believe – and in decline.

Read more…

Scotland’s currency options

One of the controversial topics in the debates of Scottish independence is the currency question. The other day, the Financial Times asked several economists to consider four options available to an independent Scotland: a currency union with the UK, sterlingisation (which would be the continued use of the pound sterling but without backing of the Bank of England), establishing a new Scottish currency, and joining the euro. Not surprisingly, opinions were divided.

However, strictly speaking, the choice is not limited to these four options. Besides, there are others which deserve a closer look as well in this context.

Read more…

Interconnectedness, uncertainty and innovation – Brian Arthur on economic complexity

The other day, Charles Consult on Twitter drew attention to a fascinating paper by W. Brian Arthur on Complexity Economics.

At a time of never-ending financial crises and lasting imbalances when people are becoming increasingly aware of the shortcomings of traditional economics with its focus on equilibrium as the natural state of an economy, Brian Arthur presents a different approach, a nonequilibrium view of economic processes and structures. In his paper, in acting and interacting firms, consumers, investors and other economic agents collectively create an outcome and then adjust their strategy in response to what they see they have created. The result of these adjustments is another outcome which causes them anew to make revisions – and so forth.

As a consequence, the economy is constantly in motion. It is not “something given and existing but forming from a constantly developing set of technological innovations, institutions, and arrangements that draw forth further innovations, institutions and arrangements.” In this scenario, equilibrium is the exception, not the rule. As the author notes: “For highly interconnected systems, equilibrium and closed form solutions are not the default outcomes; if they exist they require justification.”

Read more…

The social value of HFT – Salmon, Stiglitz and the problems of HFT reconsidered (2)

In a recent article, Felix Salmon summarized the key points of a widely noticed speech delivered by Nobel prize-winner Joseph Stiglitz on the problems of financial innovation in general, and high-frequency trading (HFT) in particular.

Stiglitz asked Are Less Active Markets Safer and Better for the Economy? and came to the conclusion that they are. His arguments revolved around three aspects: speed, costs and social value.

In the first part of this article, the speed aspect was discussed. This second part deals with the costs and social value of HFT.

Read more…


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