The great moderation Icelandic style

Reduction in the volatility in macroeconomic time series has been documented for a number of countries. This paper documents similar reduction for the Icelandic economy. The paper estimates the timing of the breakpoint and/or a trend in the variance of the series. The paper finds that the reduction in the variance in changes in Gross National Income (GNI) is larger than the reduction in the variance in the changes in GDP, both because of a reduction in the volatility in terms of trade and because of a reduction in the correlation between changes in GDP and changes in terms of trade. The largest contribution to the decline in the volatility in GNI comes though from the reduction in the volatility in GDP. The paper finds that the volatility in GDP has declined more than the volatility of its components, except export where the decline is greater. The main reason for the decline in the volatility in export is a decline in the volatility in fishing and fish processing. The paper finds that there is a strong relationship between the volatility in export and the volatility in GDP.

Accuracy in forecasting macroeconomic variables in Iceland

This paper discusses accuracy in forecasting of macroeconomic time series in Iceland. Until recently only the National Economic Institute (NEI) did macroeconomic forecasting in Iceland. Extensive analysis of forecasting can therefore only be done for the forecasts made by this institution during 1974-2002. The paper analysis macroeconomic forecasts published by the Central Bank of Iceland (CBI). It also analysis the accuracy of the first realeases of data from Statistics Iceland as “forecasts” of final (or the most recent) data during recent years. Forecasts made by international institutions like OECD and IMF are not included. The paper finds that errors in forecasting of GDP and private consumption have declined and that the performance of the forecasting for these variables has improved on some measures. But the volatility in the series has also decreased so when the forecast errors are compared to measures of the shocks that hit the economy the forecasting of changes in GDP do not seem to have improved. For some of the main components of GDP like export, imports and investments, the forecast errors have not decreased.

QMM. A steady state version

This paper studies long-run characteristics of the quarterly macro model (QMM) used at the Central Bank of Iceland; it studies if there exists a balanced growth path that QMM will replicate and if it will converge to this path. It concludes that there is no such path and therefore the model does not converge to it. The paper then studies which adjustments to QMM are required to produce a model for which there exists a realistic balanced growth path. The new model is derived with minimum changes to speci?c equations in QMM and should therefore retain its key dynamic properties. The paper checks this by comparing impulse-responses from the new balanced growth compatible model to those from QMM. Finally, the paper studies some important variables in the Icelandic economy: capital output ratio, share of wage cost, real rate of interest and equilibrium real exchange rate and their calibration for QMM. It also discusses calibration of long-run values for the exogenous variables in the model and uses the balanced growth compatible model together with these long-run values of the exogenous variables to estimate equilibrium values for endogenous variables in QMM.

On the efficacy of financial regulations.

Regulatory failures have been a significant contributor to the financial crisis, but that does not automatically mean more regulation is called for. The crisis happened because fi nancial institutions and the whole economy used seemingly infi nite amounts of cheap credit to create an asset price bubble. The banks played their part by creating all these complex structured products that continue causing difficulties. They did this under direct regulatory oversight. Such excessive credit expansion is how most financial crises have played out throughout history. The exact same process can be prevented from happening in the future, but surely the next crisis will take a different form. It will be something completely unforeseen. One cannot regulate against such unforeseen events. The crisis has its roots in the most regulated parts of the financial system, the banks, whilst the least regulated part, the hedge funds, are mostly innocent. Is the problem lack of regulation? Or is the problem lack of understanding on how to regulate financial institutions properly? Depending upon the answer to the question, the correct approach to future financial regulations will be very different. The unique element this time around has been the extensive use of statistical models to forecast prices, and risk as well as to price complex assets. It was the models that failed. Such models embed an assumption of risk being exogenous; market participants react to the financial system but do not change it. In practice, this is nonsense. Market participants, especially in a crisis, receive the same signals and react in a similar way; they exert significant price impact resulting in risk being endogenous. This implies financial risk models are the least reliable when we need them the most and that regulation by risk sensitivity, such as risk sensitive bank capital, may increase financial instability. The root causes of the crisis are the same as in most financial crises throughout history. These crises have happened under a wide range of regulatory mechanisms. Blaming the crisis on a narrow set of obvious regulatory causes, such as bonuses, hedge funds, universal banking, shadow banking, structured credit, lack of regulations, inadequate risk management is attacking a straw man. It takes the focus away from the necessary detailed examination of the causes of fi nancial instability, which is the only way to design effective regulatory mechanisms. We do not clearly understand what went wrong, and know even less how to design regulations to prevent such episodes from happening in the future, whilst maintaining the effi ciency of the financial system. This is why it would be preferable to study what went wrong and then in a few years carefully change regulations at a time when we know more. There is no hurry, we still haven’t solved this crisis and the next one will not come immediately after the current crisis. The costs of inappropriate regulations are high and we do have the time to wait.

Regulating hedge funds.

Due to the ever-increasing amounts under management and their unregulated and opaque nature, hedge funds have emerged as a key concern for policymakers. While until now, hedge funds have been left essentially unregulated, we are seeing increasing calls for regulation for both microprudential and macroprudential reasons. In our view, most calls for the regulation of hedge funds are based on a misperception of the effectiveness of financial regulations, perhaps coupled with a lack of understanding of the positive contribution of hedge funds to the financial system. There are real concerns about consumer protection following from the expansion of the consumer base. However, it would be misguided to relax accreditation criteria. A more important issue is the investment of regulated institutions, in particular pension funds, in hedge funds. Since such institutions to enjoy direct or indirect government protection, the investment in hedge funds has to be regulated. However, such regulations are best implemented on the demand side by the pension fund regulator, rather than by directly regulating the hedge fund advisors themselves. Hedge funds provide considerable benefits, not only to their investors and advisors, but more importantly to the economy at large by facilitating price discovery, market efficiency, diversifi cation, and by being potentially able to put a floor under a crisis, a function not easily implemented by regulated institutions due to a minimum capital ratios, relative performance evaluation and other considerations. It would however be imprudent to leave hedge fund advisors completely unregulated since the failure of a systematically important hedge fund has the potential to create such uncertainty as to impede trading and in a worst case scenario cause significant damage to the real economy. These issues cannot be addressed by standard regulatory methodology such as disclosure and activity restrictions. Indeed, supervisors would be well advised to leave the hedge fund sector unregulated in their normal day-to-day activities. However, the regulator needs to have the power to resolve the informational uncertainty caused by the failure of a systematically important hedge funds. Prime brokers and other client banks would in such a scenario have a de facto or a de jure obligation to participate in the expedient removal of the uncertainty. To this end targeted consultation and contingency planning is essential.

On the impact of fundamentals, liquidity and coordination on market stability

We develop a coordination game to model interactions between fundamentals and liquidity during unstable periods in financial markets. We then propose a flexible econometric framework for estimation of the model and analysis of its quantitative implications. The specific empirical application is carry trades in the yen–dollar market, including the turmoil of 1998. We find a generally very deep market, with low information disparities amongst agents. We observe occasionally episodes of market fragility, or turmoil with up by the escalator, down by the elevator patterns in prices. The key role of strategic behavior in the econometric model is also confirmed.global games, efficient method of moments, carry trades, tail risk, strategic behavior, financial crises

The method of moments ratio estimator for the tail shape parameter

The so-called Hill estimator for the shape parameter of the tail distribution is known to be downwardly biased. The Hill estimator is a moment estimator, based on the first conditional moment of the highest logarithmically transformed data. We propose a new estimator for the tail index based on the ratio of the second to the first conditional moment. This estimator has a smaller bias than the Hill estimator. We provide simulation results that demonstrate a sizable reduction in bias when a is large, while the MSE is moderated as well. The new estimator is applied to stock return data in order to resolve a long standing issue in economics

Tail index and quantile estimation with very high frequency data

A precise estimation of the tail shape of forex returns is of critical importance for proper risk assessment. We improve upon the efficiency of conventional estimators that rely on a first order expansion of the tail shape, by using the second order expansion. Here we advocate a moments estimator for the second term. The paper uses both Monte Carlo simulations and the high frequency foreign exchange recordings collected by the Olsen corporation to illustrate the technique

QMM. A Quarterly Macroeconomic Model of the Icelandic Economy

This paper documents and describes Version 2.0 of the Quarterly Macroeconomic Model of the Central Bank of Iceland (QMM). QMM and the underlying quarterly database have been under construction since 2001 at the Research and Forecasting Division of the Economics Department at the Bank and was first implemented in the forecasting round for the Monetary Bulletin 2006.1 in March 2006. QMM is used by the Bank for forecasting and various policy simulations and therefore plays a key role as an organisational framework for viewing the medium-term future when formulating monetary policy at the Bank. This paper is mainly focused on the short and medium-term properties of QMM. Steady state properties of the model are documented in a paper by Daníelsson (2009).