Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Wednesday, September 28, 2011

A blogger's ten commandments

I came by this the other day via a friend: A Liberal Decalogue, by the great philosopher Bertrand Russell. Thought you might enjoy it too.

1. Do not feel absolutely certain of anything.

2. Do not think it worth while to proceed by concealing evidence, for the evidence is sure to come to light.

3. Never try to discourage thinking for you are sure to succeed.

4. When you meet with opposition, even if it should be from your husband or your children, endeavour to overcome it by argument and not by authority, for a victory dependent upon authority is unreal and illusory.

5. Have no respect for the authority of others, for there are always contrary authorities to be found.

6. Do not use power to suppress opinions you think pernicious, for if you do the opinions will suppress you. 

7. Do not fear to be eccentric in opinion, for every opinion now accepted was once eccentric.

8. Find more pleasure in intelligent dissent than in passive agreement, for, if you value intelligence as you should, the former implies a deeper agreement than the latter.

9. Be scrupulously truthful, even if the truth is inconvenient, for it is more inconvenient when you try to conceal it.

10. Do not feel envious of the happiness of those who live a fool's paradise, for only a fool will think that is happiness.

Source: A Liberal Decalogue, Bertrand Russell (1951)

Tuesday, September 27, 2011

European banks and US dollars

I sometimes get asked why European banks are in apparent need of US dollars, and why the Fed is lending money to the European Central Bank (ECB).

Ah, the wacky world of international finance. I can't pretend to understand it fully--or even very well--but here are some thoughts nevertheless. (I'm learning a lot about this stuff from my colleague, Richard Anderson, but still lot's to learn!)

We have all heard about the apparent troubles European banks are having. They have (we believe) invested in the sovereign debt of fiscally strapped nations like Portugal and Greece; see here. Fine, you say. This might explain why they need short-term Euro financing, which the ECB can in principle supply. What the heck do they need USD for?

Well, evidently, European banks do not invest just in Europe. They also lend to companies operating in the US. Where do they get the USD to do this? A big source of  funding apparently comes from U.S. money market mutual funds (MMMFs), which lend funds to branches of these foreign banks residing on US soil. (All of this somehow is governed by the US 1978 International Banking Act -- if you understand how, please write back!)

Now, when things start to look scary in the financial market, credit begins to tighten. And it looks like the American MMMF industry is running scared from Europe. Here is an interesting tidbit, published by the Investment Company Institute (ICI), an enterprise described to me as the "public face of the U.S. MMMF industry" The piece is called Deja vu--US Money Market Funds and the Eurozone Debt Crisis (by Chris Plantier and Sean Collins). Here is an excerpt:

Direct exposure to both public and private issuers in the European “periphery” countries is virtually zero. Since June, U.S. money market funds have almost eliminated holdings of Italian and Spanish government and private debt, including bank securities. 
U.S. money market funds have reduced the maturity of their holdings in banks in Europe’s “core” (France, Germany, the United Kingdom, and other countries). According to JP Morgan Securities, 60 percent of U.S. prime money market funds’ holdings in French banks as of the end of August will mature in 30 days or less, compared to 28 percent of their holdings at the end of June. Shorter maturities provide flexibility and reduce the impact of any potential downgrades. 
According to Crane Data, at the end of July, 69 percent of money market funds’ holdings in German banks and 67 percent of holdings in British banks were set to mature in 30 days or less.

So, MMMFs are shortening the maturity structure of their lending to European banks (and raising rates). This makes European banks more susceptible to a "rollover freeze"--an event where short-term financing collapses altogether. This is the "Lehman event" that policymakers worry about for Europe.

The policy response to date has been for the Fed to re-activate its swap line with the ECB. If you go to some websites and blogs, they might describe this operation as the Fed "creating money and pumping it into Europe." One could equally well describe it as the ECB "printing up Euros and pumping them into the US." That is, at its most basic level, the two central banks are simply exchanging "green money" for "blue money." This is the nature of a swap (for those who are prone to confusing the word "swap" with "gift").

I should like to point out a fact that is seldom emphasized. The dollars that the Fed lends to the ECB through the swap line are fully collateralized (and hedged against currency risk). The ECB gives the Fed Euros in exchange for USD; the operation is then reversed a short time later (and the Fed generally earns a small return for its service). The ECB then takes these dollars and lends them those European banks "in need" of short-term USD financing--including those European banks operating on US soil, making loans to US businesses. (Essentially, the ECB is subsidizing European banks--and it is the ECB that bears the risk, not the Fed.)

Is this policy response by the Fed and the ECB justified? That's a tough one. As usual, one can make arguments pro and con.

On the pro side, one might note that US MMMFs have become somewhat skittish since the 2008 financial crisis. (You might remember an MMMF "breaking the buck" on Lehman's IOUs; see here.) They are now
very sensitive to adverse publicity about the firms they lend to (that is, invest in).  And now, it is evidently the case that banks with foreign names, even if located on US soil, might "sound" risky.

From a purely economic standpoint, this credit contraction seems a little hard to understand (but then again, who are we to argue with how creditors want to bet their money?) It is my understanding, for example, that the short-term loans issued by U.S-based branches of European banks to American companies are fully collateralized (by American capital). If this is true, and if American industry is showing no signs imminent distress, then why should a potential haircut on PIIGS debt (borne by European banks) have the American MMMF industry sufficiently worried to pull their financing (of American industry) on such a dramatic scale? Are these fears overblown? And might such overblown fears increase the likelihood of a Lehman-style event for European banks?

On the con side, we have the usual arguments for why policymakers should just let the market get down to business and resolve any outstanding credit issues. Claims of imminent contagion are made largely to justify transfers of wealth (bailouts). Moreover, there is a possibility that policy interventions, like the Fed-ECB swap line, simply delay the inevitable debt restructuring that is presently necessary. 

Monday, September 26, 2011

An interview with Bob Lucas

An interesting interview with Robert E. Lucas, Jr. by Holman Jenkins (WSJ) here: Chicago Economics on Trial.

Let's face it, the "Chicago School" of economics—the one with all the Nobel Prizes, the one associated with Milton Friedman, the one known for its trust of markets and skepticism about government—has taken a drubbing in certain quarters since the subprime crisis.

Sure, the critique depends on misinterpreting what the word "efficient" means, as in the "efficient markets hypothesis." Never mind. The Chicago school ought to be roaring back today on another of its great contributions, "rational expectations," which does so much to illuminate why government policy is failing to stimulate the economy back to life.

Robert E. Lucas Jr., 74, didn't invent the idea or coin the term, but he did more than anyone to explore its ramifications for our model of the economy. Rational expectations is the idea that people look ahead and use their smarts to try to anticipate conditions in the future.

Duh, you say? When Mr. Lucas finally won the Nobel Prize in 1995, it was the economics profession that said duh. By then, nobody figured more prominently on the short list for the profession's ultimate honor. As Harvard economist Greg Mankiw later put it in the New York Times, "In academic circles, the most influential macroeconomist of the last quarter of the 20th century was Robert Lucas, of the University of Chicago."

Mr. Lucas is visiting NYU for a few days in early September to teach a mini-course, so I dash over to pick his brain. He obligingly tilts his computer screen toward me. Two things are on his mind and they're connected. One is the failure of the European and Japanese economies, after their brisk growth in the early postwar years, to catch up with the U.S. in per capita gross domestic product. The GDP gap, which once seemed destined to close, mysteriously stopped narrowing after about 1970.

The other issue on his mind is our own stumbling recovery from the 2008 recession.

For the best explanation of what happened in Europe and Japan, he points to research by fellow Nobelist Ed Prescott. In Europe, governments typically commandeer 50% of GDP. The burden to pay for all this largess falls on workers in the form of high marginal tax rates, and in particular on married women who might otherwise think of going to work as second earners in their households. "The welfare state is so expensive, it just breaks the link between work effort and what you get out of it, your living standard," says Mr. Lucas. "And it's really hurting them."
Terry Shoffner

Turning to the U.S., he says, "A healthy economy that falls into recession has higher than average growth for a while and gets back to the old trend line. We haven't done that. I have plenty of suspicions but little evidence. I think people are concerned about high tax rates, about trying to stick business corporations with the failure of ObamaCare, which is going to emerge, the fact that it's not going to add up. But none of this has happened yet. You can't look at evidence. The taxes haven't really been raised yet."

By now, the Krugmanites are having aneurysms. Our stunted recovery, they insist, is due to government's failure to borrow and spend enough to soak up idle capacity as households and businesses "deleverage." In a Keynesian world, when government gooses demand with a burst of deficit spending, the stick figures are supposed to get busy. Businesses are supposed to hire more and invest more. Consumers are supposed to consume more.

But what if the stick figures don't respond as the model prescribes? What if businesses react to what they see as a temporary and artificial burst in demand by working their existing workers and equipment harder—or by raising prices? What if businesses and consumers respond to a public-sector borrowing binge by becoming fearful about the financial stability of government itself? What if they run out and join the tea party—the tea party being a real-world manifestation of consumers and employers not behaving in the presence of stimulus the way the Keynesian model says they should?

Mr. Lucas and colleagues in the early 1960s were not trying to undermine the conventional prescriptions when they began to think about how the public might respond—possibly in inconvenient ways—to signals about government intentions. As he recalls it, they were just trying to make the models work. "You have somebody making a decision between the present and the future. You get a college degree and it's going to pay off in higher earnings later. You make an investment and it's going to pay off later. Ok, you can't do that without this guy taking a position on what kind of future he's going to be living in."

'If you're going to write down a mathematical model, you have to address that issue. Where are you supposed to get these expectations? If you just make them up, then you can get any result you want."

The solution, which seems obvious, is to assume that people use the information at hand to judge how tomorrow might be similar or different from today. But let's be precise, not falling into the gap between "word processor people" and "spreadsheet people," as Mr. Lucas puts it. Nothing is assumed: Data are interrogated to see how changes in tax rates and other variables actually influence decisions to work, save and invest.

Mr. Lucas is quick to credit the late John Muth, who would later become a colleague for a while at Carnegie Mellon, with inventing "rational expectations." He also cites Milton Friedman, with whom Mr. Lucas took a first-year graduate course.

"He was just an incredibly inspiring teacher. He really was a life-changing experience." Friedman, he recalls, was a skeptic of the Phillips curve—the Keynesian idea that when businesses see prices rising, they assume demand for their products is rising and hire more workers—even if the real reason for higher prices is inflation.

"Milton brought this [Phillips curve] up in class and said it's gotta be wrong. But he wasn't clear on why he thought it was wrong." In his paper for Friedman's class, Mr. Lucas remembers reaching for a very rudimentary notion of expectations to try to explain why the curve could not operate as predicted.

Growing up in the Seattle area, Mr. Lucas recalls a road trip he took as a youngster that terminated in Chicago, a city with two baseball teams! Chicago, in his mind, became "the big city," a gateway to a wider world. That, and a scholarship, is how he would end up spending most of his career at the University of Chicago.

We are sitting in an inauspicious guest office at NYU. A late summer sprinkle dampens the city. Mr. Lucas describes his parents as intelligent, reading people, neither of whom finished college—he suspects the Great Depression had something to do with it. "They got into left-wing politics in the '30s, not really to do anything about it, but to talk about. That was our background—me and my siblings—relative to our neighbors and relatives, who were all Republicans." In a community not noted for its diversity, his parents were especially committed to civil rights, his mother giving talks on the subject.

I ask about a report that he voted for Barack Obama in 2008, supposedly only the second time he had voted for a Democrat for president. "Yeah, I did. My parents are dead for a long time, but my sister says, 'You have to vote for Obama, for what it would have meant for Mom and Dad.' I felt that too. It's a huge thing. This [history of racism] has been the worst blot on this country. All of a sudden this charming, intelligent guy just blows it away. It was great."

Related Video

Steve Moore and Mary O'Grady discuss the week's economic news.

A complementary consideration was John McCain's inability to say anything cogent about the financial crisis then engulfing the nation. "He didn't have a clue about the economy. I just assumed the guy [Obama] could do it. I thought he was going to be more Clinton-like in his economics and politics. I was caught by surprise by how far left the guy is and how much he's hung onto it and, I would say, at considerable cost to his own standing."

Refreshing, even bracing, is Mr. Lucas's skepticism about the "deleveraging" story as the sum of all our economic woes. "If people start building a lot of high-rises in Chicago or any place and nobody is buying the units, obviously you're going to shut down the construction industry for a while. If you've overbuilt something, that's not the problem, that's the solution in a way. It's too bad but it's not a make-or-break issue, the housing bubble."

Instead, the shock came because complex mortgage-related securities minted by Wall Street and "certified as safe" by rating agencies had become "part of the effective liquidity supply of the system," he says. "All of a sudden, a whole bunch of this stuff turns out to be crap. It is the financial aspect that was instrumental in the meltdown of '08. I don't think housing alone, if it weren't for these tranches and the role they played in the liquidity system," would have been a debilitating blow to the economy.

Mr. Lucas believes Ben Bernanke acted properly to prop up the system. He doesn't even find fault with Mr. Obama's first stimulus plan. "If you think Bernanke did a great job tossing out a trillion dollars, why is it a bad idea for the executive to toss out a trillion dollars? It's not an inappropriate thing in a recession to push money out there and trying to keep spending from falling too much, and we did that."

But that was then. In the U.S. at least, the liquidity problems that manifested themselves in 2008 have long since been addressed. To repeat the exercise now with temporary tax and spending gimmicks is to produce the opposite of the desired effect in consumers and business owners, who by now are back to taking a longer view. Says

Mr. Lucas: "The president keeps focusing on transitory things. He grudgingly says, 'OK, we'll keep the Bush tax cuts on for a couple years.' That's just the wrong thing to say. What I care about is what's the tax rate going to be when my project begins to bear fruit?"

Mr. Lucas pulls up a bit when I ask him what specific advice he'd give President Obama (this is before Mr. Obama's two back-to-back speeches, one promising temporary tax cuts and the other permanent tax hikes, which mysteriously fail to levitate the economy). Unlike many of his colleagues, Mr. Lucas has not spent stints in Washington advising politicians, or on Wall Street cashing in on his Nobel laureate reputation. "No, that doesn't interest me at all," he says. "Now I've taken a salary cut. I don't go to faculty meetings. I don't teach undergraduates. I just write papers. It's great. I feel lucky about this."

Still, an answer comes. Mr. Lucas launches into a brisk dissertation on the work of colleagues—Martin Feldstein, Michael Boskin, others—whom he credits with disabusing him and fellow economists of a youthful assumption that taxes have little effect on the overall amount of capital in society. A lesson for Mr. Obama might be: If you want to stimulate growth in investment, productivity and income, cut taxes on capital.

Alas, don't look for this idea to feature in the next Obama speech on the economy, due any minute now.
Mr. Jenkins writes the Journal's Business World column.

Update: Oh, and I just came across this today by Paul Krugman "Lucas in Context." Steve Williamson has the appropriate reply here.

Thursday, September 22, 2011

Interest rates and slumps: competing views

As Paul Krugman notes here, the nominal interest rates on U.S. Treasuries are at historic lows. He seems to take this as vindication for his view that more government "stimulus" was/is needed. (I take "stimulus" here to mean deficit-financed government purchases of goods and services.) Well, let's think about it.

First of all, I think that Krugman (along with many others) deserve credit for recognizing that money-bond swaps (Fed policy) are largely irrelevant in very depressed environments. He (again many others too) also deserve credit for understanding the special "safe haven" role that U.S. Treasury debt plays in today's world economy. But does understanding all this necessarily lead to the conclusion that what the economy needs is more (it never seems to be enough) government "stimulus?"

Some of our economic theories suggest that the answer is yes, while some suggest no. What Krugman is suggesting is that the latter group of theories should be discarded because their predictions on nominal interest rates have been completely wrong. He is getting a little ahead of himself here.

Unfortunately for Krugman, there are theories out there that generate predictions broadly consistent with the data but which do not lead to the same policy conclusion.  One such theory is the "new monetarist" model I published for the Bank of Japan (during my visit there in 2002): Monetary Implications of the Hayashi-Prescott Hypothesis for Japan. (See also here.)

The basic story is this. First, it is conceivable that "real" factors are contributing to a "growth slowdown." Here, one is free to pick your favorite bogeyman. Maybe it's becoming more difficult to expand the technological frontier (see, for example, Tyler Cowen). Maybe it's the fear that people (via their political representatives) will become more interested in appropriating wealth, rather than creating it (see, for example, The Grabbing Hand).  Whatever the case may be, the upshot is that people--investors, in particular--are rationally pessimistic (over the future after-tax return to their investment activities today).

In the model I used in my BoJ paper (an overlapping generations model), rational pessimism generates a "flight to quality"--people begin to substitute government money/debt for private assets. The effect is deflationary (driven by the increase in real money demand). The economy looks like it is suffering from "deficient demand" (it is not). There is downward pressure on the real interest rate (as the demand for investment contracts). These are not crazy predictions.

In my model economy, the central bank has control over the real interest rate, and cuts in the interest rate stimulate investment and (future) GDP. When the nominal interest rate hits zero, the central bank can no longer influence the real interest rate via money-bond swaps (i.e., there is a "liquidity trap"). Real activity may be stimulated, however, by increasing the inflation target (the operation must be undertaken by the fiscal authority in my model; the monetary authority is powerless in a liquidity trap). It might also be possible for increases in G to expand GDP (as is the case in many neoclassical models). All of this is true. And yet, it does not follow that any of these "stimulus" programs are necessarily desirable (among other things, it depends on what social welfare function one adopts).

Now, I'm not absolutely sure about the empirical relevance of my little model. This is because I can think of another theory that generate predictions that are observationally equivalent to my model, and yet delivers very different policy prescriptions.

The model is the one evidently used by Krugman, DeLong, and others (Nick Rowe?). In a nutshell, recessions are caused by an increase in money (treasury) demand. That's just like in my model. But there is a big difference. In their view (as far as I can tell), the pessimism that drives up the demand for money is attributable to "irrational" fear. And if the private sector is afraid of spending, maybe the government sector should step in and take its place.

But perhaps this is not entirely fair. There is, in fact, a literature that explains how expectations can become self-fulfilling prophesies. I could, for example, modify my model to incorporate a form of increasing returns to scale in the economy's production technology. This could generate what economists call "multiple equilibria." Each equilibrium is determined by expectations. If  people are optimistic, good things occur. If people are pessimistic, bad things occur. The pessimistic expectations are "rational" at the individual level, but not at the social level. There is potentially a role for policy here.

Krugman, DeLong and Rowe do not frame things in quite this way, so I'm not sure if this is what they are talking about. But Roger Farmer has been working in this area for a long time and I think his ideas are finally starting to gain some traction; see The Fear Factor.

Anyway, my basic point here is, as always, that we need to be more circumspect in our claims about what we know for sure. Beware of economists that make claims like this

Monday, September 19, 2011

Fractional reserve banking

Fractional reserve banking is sometimes portrayed as a sort of scam; a method by which rich bankers  underhandedly sap the wealth of society. This short video here, How Fractional Reserve Banking Increases Inflation and Steals our Wealth, is fairly representative of a view I hear expressed quite often.

As you might have guessed, I think that this view is somewhat distorted and misleading. Let me explain why I feel this way.

The video starts off with an hypothetical depositor who starts off with $1000 and asks what happens when it is deposited. Right away we are off to a poor start.

Does he mean starting off with $1000 of cash? Or does he mean $1000 of money (say, in the form of a paycheck)? It makes a difference. When was the last time you made a cash deposit? If you are like me, you cannot remember when. Of course, money gets "deposited" all the time in your account. At work, for example, you might be paid by check or by direct deposit. But this is not what the guy means by "making a deposit"--these "deposits" are simply debit and credit operations in a linked system of accounts (your paycheck is credited to your account, and is debited from your company's account). What the guy means by a "deposit" is a cash deposit. The main source of cash deposits in all likelihood originates from the cash registers of retail businesses.

Alright then, evidently there is cash in circulation. These days, cash primarily takes the form of small denomination paper notes issued by a central bank, like the Fed (in the past, cash frequently took the form of specie--gold and silver coin). There is a demand for cash. Cash is useful for purchasing some types of goods and services when no other means of payment is available. (Cash is also used when transactors wish to keep their exchanges anonymous). And so people occasionally visit ATMs to make cash withdrawals. This cash ultimately finds its way in the cash registers of businesses (however, it is estimated that a lot circulates in the underground economy and, in the case of the U.S., outside of the country).

O.K., so where does banking fit in all this? Maybe your ideal view of a bank is simply as a place to keep your cash safe, kind of like your piggy bank. You deposit your cash with the bank, and the bank issues you a receipt, which constitutes a record of your cash deposit and represents a claim for cash (deliverable by the bank). Or the bank may simply record your deposit as a book entry item. Either way, your cash deposit constitutes a liability for the bank. These liabilities are sometimes called "bank-money" because, well, because they can be used as money. Receipts (especially if they are made payable to the bearer) can potentially circulate as money. Similarly, checks can be written ordering the transfer of cash sitting at the bank from one account to another. If the value of liabilities issued by the bank do not exceed the amount of cash it holds as assets, then we call this 100% reserve banking. (The liabilities issued by the bank are backed 100% by cash.)

Of course, banks do not just keep your cash safe and perform debit/credit transactions for you. They also make money loans. And here is where the confusion generally begins. It starts with the idea that the bank might have the temerity to lend YOUR cash out to someone else--at interest, to boot!

Well, that's not quite what happens. Let try me explain (well, to the best of my understanding, of course).

Suppose you want to start a restaurant business. You own the property and building, but nothing else (apart from your human capital). The building needs to be made into a restaurant. You need ovens, utensils, rooms to be made and finished, furniture, staff, advertising, accountants, lawyers, etc. How do you pay for all this stuff? You clearly have wealth (physical and human capital). You just don't have any cash.

But what do you need cash for anyway? Why not pay for all this stuff using your wealth? One way to do this, in principle at least, is to issue receipts representing shares in your wealth. These shares are liabilities against your wealth. Each share represents an IOU against the future income stream generated by your capital. (The IOUs could take a variety of forms. They could, for example, be made into coupons redeemable for food from your restaurant--something very similar to Canadian Tire Money).

Um, one problem. If you're like me, not very many people know who you are. A randomly selected member of society is unlikely to recognize us, or have any idea what we really own, or have any idea how well we might live up to the promises (IOUs) we issue. Basically, most of us are anonymous (except for within a relatively small network of friends and business relations--and even then, we keep a lot of information private). Anonymity renders our capital illiquid (it is not easily or widely accepted as a means of payment).

O.K., so scratch the idea of creating your own money. This is where a bank now comes in. Let's imagine that the bank reviews your business proposal and concludes that it is likely to be profitable. The bank also thinks that your capital is of high quality and that your ownership title is clear (btw, you are now no longer anonymous to the bank). Now, you might think that the bank is then going to lend you the cash you need to finance your operations. Well, you would be wrong (sort of). That is, you do not need cash--what you want is bank-money. And that's what you typically get from the bank: a money loan in the form of bank liabilities (not cash).

Now, the commentator in that video claims that this bank-money is created out of thin air. That is both correct and completely irrelevant; see my earlier post here. The bank-money (whether in the form of paper notes or book-entry objects) are backed by the assets you put up as collateral for your loan. As long as the loans officer makes good decisions about which business ventures to lend money to, the bank-money created by the bank is fully backed (and consequently, not inflationary; i.e., the new money issue is not dilutive). What the bank has in effect done here is transform your illiquid capital into a liquid liability. This is hardly an activity that one might reasonably label as being inherently "evil."

But this is not quite the end of the story. I have just made the claim that banks issue fully-backed liabilities that serve as money instruments. If this is true, then what do people mean by fractional reserve banking? Let me explain.

In practice, banks issue a very peculiar type of liability, called a demand-deposit liability. In the lingo of financial wonks, these are liabilities that have embedded within them a contractual stipulation known as an American put option. This option gives the debt holder (the depositor) the right to exercise a redemption option on demand at a fixed price. The redemption option in this case consists of the right to redeem bank-money for cash on demand (and usually at par, but frequently subject to a service charge). This is what happens every time you make a withdrawal of cash from your bank or an ATM.

Why do banks do this? Isn't is a recipe for potential trouble?

I don't know why banks do this. In many jurisdictions, it may constitute a legal restriction (as part of the bank charter). I'm not sure if the restriction is binding, however. That is, it is my understanding that banks used to do this even when they were not legally required to do so. Evidently, the redemption option is valued by those who make use of bank-money.

I am aware of only two (not necessarily mutually exclusive) explanations for this contractual stipulation. One is that consumers value insurance against "liquidity shocks" (events were only cash is accepted). The other is that the redemption option serves as sort of a discipline device for bank managers (see Calomaris and Kahn, AER 1991). That is, the put option makes the bank's liability a very short-term debt instrument, so that depositors can potentially pull out very quickly if they sense any hanky-panky. The threat of mass redemptions (and the bankruptcy it would entail) is presumably enough to dissuade self-interested bankers from absconding with depositor wealth.

Sounds wonderful except that, of course, only a very small fraction of a bank's assets are typically in the form of cash. Most of the bank's assets are tied up in "long-term illiquid" assets, like your house, or your human capital. Consequently, while the bank's liabilities may be fully backed, only a small part of this backing is in the form of cash. This is the true nature of fractional reserve banking.

The potential trouble, of course, comes to play when a bank (or worse, the banking system as a whole) is subject to a wave of mass redemptions. There is simply not enough cash in the banking system to honor all of its short-term debt obligations simultaneously. (This is not fraud or deceit; it is something that everyone is--or should be--plainly aware of.) In this event, banks are compelled to sell off their assets to raise the cash they need. This is not something that all banks can all accomplish simultaneously; at least, not without depressing asset values and creating a deflation (the fall in the price-level reflects an increase in the demand for, hence value of, cash relative to goods and services).

There are basically two (possibly more, as readers have suggested below) ways to eliminate retail-level banking panics (waves of mass redemptions). Neither are without cost. One way is to adopt some sort of national deposit insurance system. This is the system that presently exists in the United States (FDIC plus the Fed discount window). People criticize this system because it allegedly promotes moral hazard (banks are induced to take on excessively risky investments). On the other hand, the U.S. has not experienced a retail-level bank run since the Great Depression.

The other way to eliminate retail-level banking panics is to pass legislation requiring all banks to hold 100% cash reserves. This would, of course, kill the business that transforms your illiquid assets into a liquid payment instruments. But it would not necessarily kill the prospect of bank-run-like phenomena. This is because bank-run-like phenomena can emerge even without fractional reserve banking. The phenomenon is possible whenever short-term debt is used to financed long-term (illiquid) asset purchases, as is the case in the wholesale-level banking sector (the so-called "shadow banking" sector).

The use of short-term debt to finance long-term asset purchases (think of the overnight repo market) is, again, a very peculiar financing structure. Like the demand deposit liability, the structure is likely explained by the need to align incentives. While this structure may enhance efficiency along some dimension, it comes at a cost. The analog to a bank run here is a "roll over freeze." This is an event where creditors (depositors) refuse to rollover their short-term funding en masse. In this event, debtors must now scramble to raise funds or dispose of their assets (at "firesale" prices).

If this sounds familiar, it should: it is exactly what happened in our most recent financial crisis. It is also what policymakers currently fear might happen to European banks (who have borrowed USD short-term, to finance longer-term asset purchases; see here). 

Friday, September 16, 2011

What Scott Sumner Knows for Certain

Love TheMoneyIllusion. But does Scott go a little too far with this proclamation?

Here’s what we know for certain about the US business cycle:
1.  If nominal wages are highly sticky, then NGDP slowdowns will raise unemployment.
2.  Nominal wages are highly sticky for at least some workers.
3.  The period after mid-2008 saw the largest NGDP growth collapse since the Great Depression.
4.  The period after mid-2008 saw a huge rise in unemployment.

Points 3 and 4 are empirical statements (and they are true).

Point two sounds like an empirical statement too, but it is not really. The reason is that there are many different theoretical (and empirical) notions of what exactly constitutes a "sticky" nominal wage. Most people have in mind the idea that nominal wage rates do not appear to adjust quickly to changing economic circumstances. But ideally, the concept should be defined more precisely than this (preferably within the context of an explicit economic model). At the very least, we could then be absolutely certain that we were talking about the same thing!

(The other thing I should like to point out here is that people often ignore the huge monthly gross flows of workers into and out of employment. The wages of these workers likely display much more flexibility than those workers employed for some time at a given establishment. I discuss turnover issues here.)

The first point is clearly a theoretical proposition: if X, then Y. As a theoretical proposition, it is likely to remain valid only under a set of specific conditions. Unfortunately, Scott does not provide us with the model he has in mind. And to make matters worse, he seems to want to make us believe that, whatever this model is, it "for certain" applies to the U.S. economy. (Most of what I am complaining about is probably the by-product of loose blogger language, but I think it's important for some things to be more precise.)

Now, I can certainly think of a model that might deliver something resembling the proposition in question. Think of a neoclassical labor market model, where money is somehow necessary, and were nominal price adjustment (or formulating contingent contracts) is costly. Then think of an exogenous decline in the price level (who knows what might have been responsible for that). The implication is that the real wage rises and that this reduces the demand for labor (though why this translates into an increase in unemployment, and not an increase in non-participation, is not usually discussed).

As I have argued elsewhere (The Sticky Price Hypothesis: A Critique), Marshall's scissors (static supply and demand curves) are probably not the best tool we have available to interpret the labor market. The labor market is a a market in relationships, much like the marriage market. The spot wage is irrelevant in enduring relationships; what matters is the time-path of wages and the division of the joint surplus. There are many different wage paths that cost the firm the same in net present value terms. A "sticky" wage (whether real or nominal) need not have any allocative consequences.

I therefore confess that I, for one, do not know "for certain" that if nominal wages are sticky, then NGDP slowdowns will raise unemployment.
It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. Mark Twain

Tuesday, September 13, 2011

What makes a central bank special?

Nick Rowe over at WCI has an interesting post asking what makes a central bank special; see Currency, Interest, and Redeemability.

According to Nick, what makes a central bank special is not that it can borrow and lend, create money, and set interest rates. All of us can do these things in principle; and in practice, many large private financial institutions do do these things. The difference, as Nick explains, is what he calls "asymmetric redeemability." The Bank of Montreal, for example, issues money redeemable in BoC liabilities; but the reverse is not true.

I think that's right; but let me expand with a few related thoughts of my own.

If one looks at history, a recurring property of monetary economies is the emergence of a "base money" that serves as the redemption object for "broad money" objects. Frequently, the broad money is made redeemable, on demand, and at par, with the base money. (We might even call base money "central" money, as it serves as the focal point for all other monies.)

In modern economies, the demandable liabilities created by chartered banks (M1, say) constitute broad money made redeemable, on demand, and at par, with government cash (small denomination paper). In the antebellum US, private banknotes were made redeemable on demand at par for specie (gold and silver coin). And so on throughout much of recent monetary history.

Now, there are a lot of interesting questions that arise here that are not the main focus of my post here. For example, why do banks embed their liabilities with what amounts to be an American put option (liabilities made redeemable on demand at a fixed strike price)? Is it the byproduct of a legal restriction, or is it an equilibrium phenomenon?

Either way, it seems obvious that the agency in control of the supply of base money (the object of redemption) is going to be in a position to implement "monetary policy." Whether this is a good or bad thing is the subject of much debate of course (let's not get into that here). And so, I have to agree with Nick's conclusion:

There is something very seriously wrong with any approach to monetary theory which says we can assume central banks set interest rates and ignore currency. It is precisely those irredeemable monetary liabilities of the central bank (whether they take the physical form of paper, coin, electrons, does not matter) that give central banks their special power.

(He is, however, not quite right about private agencies not being able to issue irredeemable objects and get them to be used them as money; see Bitcoin).

Scott Sumner, who runs a very nice blog himself, has an interesting take on Nick's post; see: The Bank of Canada is Important Precisely Because it is not a Bank.  Here is Scott:

Now let’s consider a different monetary system.  Imagine a gold standard and a monopoly producer of gold.  The gold mine company would reduce short term interest rates by increasing the supply of gold.  Like currency, gold is irredeemable.  But no one would call this gold mining company a “bank” because it possesses no bank-like qualities.  Banks don’t create irredeemable assets, gold mines do.

Scott is trying to tell us that a central bank is not a bank; it is the monopoly supplier of base money. He also says that "banking has nothing to do with monetary policy."

I find it difficult to evaluate this view because he does not define "bank" or "monetary policy" here (although I'm sure he does elsewhere). Permit me once again to give my 2 cents worth.

A financial intermediary is an asset transformer. An insurance company, for example, takes "deposits" (premiums), purchases assets, and creates a set of state-contingent liabilities backed by these assets. A pension fund, as another example, takes "deposits" (contributions), purchases assets, and creates a set of time-contingent liabilities backed by these assets. A bank, finally, takes "deposits", purchases (or finances) assets, and creates a set of demandable liabilities backed by these assets.

So a bank is a special kind of intermediary. It is special because the demandable liabilities created by banks are used widely as payment instruments; i.e., money (and the demandable property of these liabilities probably goes a long way to enhancing their acceptability as money, but that's another story).

When a bank accepts your land as collateral for a money loan, it performs an asset swap. It is transforming your illiquid land into a liquid asset (the liability created by the bank). Banks are in the business of transforming illiquid assets into liquid assets. This leads us to ask what the Fed is doing when it purchases (say) MBS or UST assets? In my view it is transforming (relatively) illiquid assets into a very liquid asset (Fed cash). QE is banking; and it falls under the category of monetary policy, in my books at least.

So in some sense, all banks (private and public) are engaged in a form of  "monetary policy." But it still remains true that a central bank with legislated monopoly control over the economy's base money object is "special" precisely for this reason. And any theoretical framework that is to have any hope of ever understanding the role of money and banking in society is going to have to model these objects explicitly; the way this guy does, for example. 

Monday, September 5, 2011

Burtless: It's *not* regulatory and tax uncertainty

Gary Burtless, an economist at the Brookings Institution, seems pretty sure that the relatively depressed levels of U.S. business investment and employment have nothing to do with the alleged uncertainty over future tax and regulatory regimes. Mark Thoma reports the story here.

The main thrust of the argument is contained in the following paragraph:
Then why was uncertainty about taxes and the future burden of the Affordable Care Act holding back business investment right now? If managers thought taxes or regulatory costs might go up in the future, wouldn't it make sense to take advantage of today's low taxes and lower burdens to invest and hire today? According to the "uncertainty" argument, businesses are fearful they might face high taxes and extra health cost in 2016 and 2018. Shouldn't they expand hiring right now and scale back employment when they actually face higher costs (if they ever do)?
Burtless raises some good questions here, but I don't think they are the nail-in-the-coffin he makes them out to be. Why not more investment now, if taxes might go up in 2016 or 2018?

First of all, I'm not sure that those are the only dates businesses have to consider (governments can raise taxes anytime). Second, many large capital projects take a lot more than just a few years to complete. Think about the act of committing a large amount of capital (belonging to you, your friends, your creditors, your shareholders) destined to payoff (if at all) sometime in the distant future. Once committed, this capital is almost completely irreversible and--significantly--it is easily appropriated, since capital cannot run away once it is built). Is it completely crazy to imagine that those contemplating such investments in the current economic climate might want to worry (among other things) the possibility of future changes in tax regime?

Well, maybe my argument does not work so well for employment. As Burtless suggests, why not hire people now and then lay them off if and when taxes rise? One response to this is: How does he know for sure that the future regulatory climate will allow firms to lay off people in this easy manner? If the U.S. is moving to a more European-style economic model (and I'm not saying here whether this is good or bad), then firms may at some point in the future face large penalties for letting workers go.

So what is the problem, according to Mr. Burtless. Predictably, it is this:
The odd thing is, when businesses are asked why they're not expanding, "high taxes" and "heavy regulatory burdens" and "tax uncertainty" don't feature as prominent answers. They mostly say they don't see good prospects for extra sales. But right-wing economists have their talking point, even if they make little sense, and they're sticking to them.
Ah yes, those evil right-wing economists (one can see the halo hovering over his head as he says this).

I've tackled the issue of how firms reply to these business surveys here: Deficient Demand: The Deflated Balloon Hypothesis. Basically the idea is as follows. Consider any shock that leads to a contraction in one sector of the economy. Imagine that sectors are characterized by an interlinking network of demands for intermediate goods and services. A collapse in residential construction can now be expected to reverberate throughout the economy. A decline in the demand for housing also leads to a decline in the demand for all the products that go into making houses. It would not be surprising for someone in the business of producing (say roof shingles) to report that his or her main problem appears to be a "lack of demand" for their product.  But that by itself does not constitute evidence that the macroeconomic problem is a "lack of aggregate demand."

Burtless may very well end up being correct in his assessment. I'm just not sure how he knows for sure that what he says is true.

Updates: September 06, 2011

Regime Uncertainty: The Real (Option) Deal, Craig Pirrong
This is a direct rebuttal to Burtless (h/t Prof J)

Other related links:
Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War, Robert Higgs
The Great Recession and Government Failure, Gary Becker (h/t Alex Karaivanov)