I just ordered “Fragile by Design”

I must admit that I am a bit of a “serial shopper” when it comes to buying books on Amazon. Today I (pre) ordered a book I have been waiting for some time –  “Fragile by Design: Banking Crises, Scarce Credit,and Political Bargains”  by Charles Calomiris and  Stephen Haber. I have written about the book before:

For natural reasons I have not read the book yet, but in a couple of recent papers and presentations by Calomiris and Haber have spelled out the main ideas of the book (See for example hereherehere andhere). I find their large survey of history of banking crisis tremendously interesting and I find it particularly interesting that Calomiris and Haber conclude that the root cause of banking crisis has to be found in what political institutions different countries have. Said in another way the main cause banking crisis is one of “political design”.

One of the main views of Calomiris and Haber is that some countries are a lot more prone to banking crisis than other. Calomiris and Haber list the following countries as particularly prone to banking crisis: Argentina, the Democratic Republic of the Congo, Chad, the Central African Republic, Cameroon, Guinea, Kenya, the Philippines, Nicaragua, Brazil, Bolivia, Costa Rica, Thailand, Mexico, Ecuador, Colombia, Uruguay, Chile, Turkey, Spain, Sweden and the United States.

Similarly Calomiris and Haber list a number of countries that in general have been crisis free (despite abundant credit):  Bahamas, Malta, Cyprus, Brunei, Singapore, Hong Kong, Macao, South Africa, Italy, Austria, New Zealand, Australia, and Canada.

The differences between USA and Canada seem to be particularly interesting (discussed in Chapter six of the book). Hence, since 1840 the US have had 14 banking crisis, while Canada have had none and this despite of the fact that credit have been as abundant in Canada as in the US. While the two countries have the a very similar cultural and colonial  history the political institutions in Canada and the USA are very different. These differences in political institutions according to Calomiris and the US have lead to the development of vastly different banking systems in the two countries – “branch banking” in Canada and “unit banking” in the US.

There are a lot more in the book than what I have discussed above and the papers that Haber and Calomiris already have put out are extremely interesting and insightful so I can’t wait to read the book!

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What are Crashes in Cycling’s Grand Tours telling us about banking crisis?

The concept of moral hazard can often be hard to explain to non-economists – or at least non-economists are often skeptical when economists try to explain excessive risk taking in banking with moral hazard problems. Non-economists often prefer a simpler explanation to banking crisis – bankers are simply evil and greedy bastards.

But maybe if we – as economists – use something that most people would understand – sports – to explain moral hazard we might be more successful when we want to explain moral hazard in banking.

Just take a look at the abstract from a recent paper – Does the Red Flag Rule Induce Risk Taking in Sprint Finishes? Moral Hazard Crashes in Cycling’s Grand Tours – from the Journal of Sports Economics:

Sprint finishes in professional cycling are fast, furious, and dangerous. A ‘‘red flag rule’’ (RFR) seeks to moderate the chaos of these finishes, but may induce moral hazard by removing the time penalty associated with crashing. To test for moral hazard, the authors use a 2005 rule change that moved the red flag from 1 km to 3 km from the finish. Data from Europe’s Grand Tours indicate that, after the rule change, both the incidence and the size of crashes nearly doubled in the 1–3 km from the finish zone. There was no such increase in crashing rates in the 3–5 km zone.

I love Sportometrics or the Economics of Sports not only because it tells us about sports, but also because sports is a good way of testing economic theories such as moral hazard. It is real-life experimental economics.

Therefore, I think that if we can show that if you reduce the “cost” of crashing in a bike race with a rule like the “red flag rule” then you will increase “risk taking” then it is only natural also to expect bankers to take excessive risks if there is a similar “red flag rule” in banking – such as deposit insurance.

This also shows that if we try to make the “game” more safe then the end result might very well be the opposite.  Regulators and bankers alike should realise this.

Property rights and banking crisis – towards a “Financial Constitution”

I just found a great paper – “A Coasean Approach to Bank Resolution Policy in the Eurozone” – on banking resolution by Gregory Connor and Brian O’Kelly. Here is the abstract:

“The Eurozone needs a bank resolution regime that can work across seventeen independent nations of diverse sizes with varying levels of financial development, limited fiscal co- responsibility, and with systemic instability induced by quick and low-cost deposit transfers across borders. We advocate a Coasean approach to bank resolution policy in the Eurozone, which emphasises clear and consistent contracts and makes explicit the public ownership of the externality costs of bank distress. A variety of resolution mechanisms are compared including bank debt holder bail-in, prompt corrective action, and contingent convertible bonds. We argue that the “dilute-in” of bank debt holders via contingent convertibility provides a clearer and simpler Coasean bargain for the Eurozone than the more conventional alternatives of debt holder bail-in or prompt corrective action.”

I found the paper as I was searching the internet for papers on banking regulation and property rights theory. If we fundamentally want to understand banking crisis we should understand incentives and property rights.

Who owns “profits” and “liability”? Who will be paying the bills? The banks’ owners, the clients, the employees, the bank management or the taxpayers? If property rights are badly defined or there are incentive conflicts we will get banking troubles.

In that sense banking crisis is a constitutional economics problem. Therefore, we cannot really understand banking crisis by just looking at specific issues such as how much capital or liquidity banks should hold. We need to understand the overall incentives facing all players in the “banking game” – owners, clients, employees, bank managements, regulators and politicians.

Inspired by Peter Boettke’s and Daniel Smith’s for a “Quest for Robust Political Economy” of monetary policy we could say we need a “Robust Political Economy of Financial Regulation”. I believe that Connor’s and O’Kelly’s paper contributes to this.

Another paper that helps use get a better understanding of the political economy of financial regulation and crisis is Josh Hendrickson’s new paper “Contingent Liability, Capital Requirements, and Financial Reform” (forthcoming in Cato Journal). Here is the abstract:

“Recently, it has been argued that banks hold an insufficient amount of capital. Put differently, banks issue too much debt relative to equity. This claim is particularly important because, all else equal, lower levels of capital put banks at greater risk of insolvency. As a result, some have advocated imposing capital requirements on banks. However, even if one accepts the proposition that banks hold too little capital, it does not neces- sarily follow that the correct policy response is to force banks to hold more capital. An alternative to higher capital requirements is a system in which banks have contingent liability. Under contingent liability, shareholders are liable for at least some portion of depositor losses. This alternative is not unprecedented. Historical evidence from the United States and elsewhere suggest that banks with contingent liability have more desirable charac- teristics than those with limited liability and that depositors tend to pre- fer contingent liability when given the choice. Successful banking reform should be aimed at re-aligning bank incentives rather than providing new rules for bank behavior.”

Lets just take the last sentence once again – “Successful banking reform should be aimed at re-aligning bank incentives rather than providing new rules for bank behavior.” 

Hence, if we want to “design” good banking regulation we fundamentally need a property rights perspective or even in a broader sense a “Financial Constitution” in the spirit of James Buchanan’s “Monetary Constitution”.

Concluding, yes we might learn something about banking crisis and banking regulation by studying finance theory, but we will probably learn a lot more by studying Law and Economics and Public Choice Theory.

Related posts:

“Fragile by design” – the political causes of banking crisis
Beating the Iron Law of Public Choice – a reply to Peter Boettke

Indian superstar economists, Egyptian (not so liberal!) dictators, the Great Deceleration and Taliban banking regulation – Some more unfocused musings

While the vacation is over for the Christensen family I have decided to continue with my unfocused musings. I am not sure how much I will do of this kind of thing in the future, but it means that I will write a bit more about other things than just monetary issues. My blog will still primarily be about money, but my readers seem to be happy that I venture into other areas as well from time to time. So that is what I will do.

Two elderly Indian economists and the most interesting debate in economics today

In recent weeks an very interesting war of words has been playing out between the two giants of Indian economic thinking – Jagdish Bhagwati and Amartya Sen. While I don’t really think that they two giants have been behaving themselves in a gentlemanly fashion the debate it is nonetheless an extremely interesting and the topic the are debate – how to increase the growth potential of the Indian economy – is highly relevant not only for India but also for other Emerging Markets that seem to have entered a “Great Deceleration” (see below).

While Bhagwati has been arguing in favour of a free market model Sen seems to want a more “Scandinavian” development model for India with bigger government involvement in the economy. I think my readers know that I tend to agree with Bhagwati here and in that regard I will also remind the readers that the high level of income AND the high level of equality in Scandinavia were created during a period where all of the Scandinavian countries had rather small public sectors. In fact until the mid-1960s the role of government in Scandinavia was more limited than even in the US at the same time.

Anyway, I would recommend to anybody interested in economic development to follow the Bhagwati-Sen debate.
Nupur Acharya has a good summery of the debate so and provides some useful links. See here.

By the way this is Bhagwati’s new book – co-authored with Arvind Panagariya.

Bhagwati

The Economics of Superstar Economists

Both Bhagwati and Sen are what we call Superstar economists. Other superstar economists are people like Tyler Cowen and Paul Krugman. Often these economists are also bloggers. I could also mention Nouriel Roubini as a superstar economist.

I have been thinking about this concept for a while  and have come to the conclusion that superstar economists is the real deal and are extremely important in today’s public debate about economics. They may or may not be academics, but the important feature is that they have an extremely high public profile and are very well-paid for sharing their views on everything – even on topics they do not necessarily have much real professional insight about (yes, Krugman comes to mind).

In 1981 Sherwin Rosen wrote an extremely interesting article on the topic of The Economic of Superstars. Rosen’s thesis is that superstars – whether in sports, cultural, media or the economics profession for that matter earn a disproportional high income relative to their skills. While, economists or actors with skills just moderately below the superstar level earn significantly less than the superstars.

I think this phenomenon is increasingly important in the economics profession. That is not to say that there has not been economic superstars before – Cassel and Keynes surely were superstars of their time and so was Milton Friedman, but I doubt that they were able to make the same kind of money that Paul Krugman is today.  What do you think?

The Great Deceleration – 50% structural, 50% monetary

The front page of The Economist rarely disappoints. This week is no exception. The front page headline (on the European edition) is “The Great Deceleration” and it is about the slowdown in the BRIC economies.

I think the headline is very suiting for a trend playing out in the global economy today – the fact that many or actually most Emerging Markets economies are loosing speed – decelerating. While the signs of continued recovery in the developed economies particularly the US and Japan are clear.

The Economist rightly asks the question whether the slowdown is temporary or more permanent. The answer from The Economist is that it is a bit of both. And I agree.

There is no doubt that particularly monetary tightening in China is an extremely important factor in the continued slowdown in Emerging Markets growth – and as I have argued before China’s role as monetary superpower is rather important.

However, it is also clear that many Emerging Markets are facing structural headwinds – such as negative demographics (China, Russia and most of the rest of Central and Eastern Europe), renewed “Regime Uncertainty” (Egypt, Turkey and partly South Africa) and old well-known structural problems (for example the protectionism of India and Brazil).  Maybe it would be an idea for policy makers in Emerging Markets to read Bhagwati and Panagariya’s new book or even better Hernando de Soto’s “The Mystery of Capital – Why Capitalism Triumphs in the West and Fails Everywhere Else”

Egypt – so much for “liberal dictators”

While vacationing I wrote a bit Hayek’s concept of the “liberal dictator” and how that relates to events in Egypt (see here and here). While I certainly think that the concept a liberal dictatorship is oxymoronic to say the least I do acknowledge that there are examples in history of dictators pursuing classical liberal economic reforms – Pinochet in Chile is probably the best known example – but in general I think the idea that a man in uniform ever are going to push through liberal reforms is pretty far-fetched. That is certainly also the impression one gets by following events in Egypt. Just see this from AFP:

With tensions already running high three weeks after the military ousted president Mohamed Morsi, General Abdel Fattah al-Sisi’s call for demonstrations raises the prospect of further deadly violence.

…Sisi made his unprecedented move in a speech broadcast live on state television.

“Next Friday, all honourable Egyptians must take to the street to give me a mandate and command to end terrorism and violence,” said the general, wearing dark sunglasses as he addressed a military graduation ceremony near Alexandria.

You can judge for yourself, but I am pretty skeptical that this is going to lead to anything good – and certainly not to (classical) liberal reforms.

Just take a look at this guy – is that the picture of a reformer? I think not.

Dictator

Banking regulation and the Taliban

Vince Cable undoubtedly is one of the most outspoken and colourful ministers in the UK government. This is what he earlier this week had to say in an interview with Finance Times about Bank of England and banking regulation:

“One of the anxieties in the business community is that the so called ‘capital Taliban’ in the Bank of England are imposing restrictions which at this delicate stage of recovery actually make it more difficult for companies to operate and expand.”

While one can certainly question Mr. Cable’s wording it is hard to disagree that the aggressive tightening of capital requirements by the Bank of England is hampering UK growth. Or rather if one looks at tighter capital requirements on banks then it is effectively an tax on production of “private” money. In that sense tighter capital requirements are counteracting the effects of the quantitative easing undertaken by the BoE. Said in another way – the tight capital requirements the more quantitative easing is needed to hit the BoE’s nominal targets.

That is not to say that there are not arguments for tighter capital requirements particularly if one fears that banks that get into trouble in the future “automatically” will be bailed out by the taxpayers and the system so to speak is prone to moral hazard. Hence, higher capital requirements in that since is a “second best” to a strict no-bailout regime.

However, the tightening of capital requirements clearly is badly timed given the stile very fragile recovery in the UK economy. Therefore, I think that the Bank of England – if it wants to go ahead with tightening capital requirements – should link this the performance of the UK economy. Hence, the BoE should pre-annonce that mandatory capital and liquidity ratios for UK banks and financial institutions in general will dependent on the level of nominal GDP. So as the economy recovers capital and liquidity ratios are gradually increased and if there is a new setback in economy capital and liquidity ratios will automatically be reduced. This would put banking regulation in sync with the broader monetary policy objectives in the UK.

 

Dear Northern Europeans – Monetary easing is not a bailout

If we want to explain the Market Monetarist position on banking crisis then it would probably be that banking crisis primarily is a result of monetary policy, but also that moral hazard should be avoided and a strict ‘no bailout’ policy should be implemented. However, the fact that Market Monetarists now for example favour aggressive monetary easing in the euro zone, but at the same time are highly skeptical about bailouts of countries and banks might confuse some.

I have noticed that there generally is a problem for a lot of people to differentiate between monetary easing and bailouts. Often when one argues for monetary easing the reply is “we should stop bailing out banks and countries and if we do it we will just create an even bigger bubble”. The problem here is that Market Monetarists certainly do not favour bailouts – we favour nominal stability.

I think that at the core of the problem is that people have a very hard time figuring out what monetary policy is. Most people – including I believe most central bankers – think that credit policy is monetary policy. Just take the Federal Reserve’s attempt to distort relative prices in the financial markets in connection with QE2 or the ECB’s OMT program where the purpose is to support the price of government bonds in certain South European countries without increasing the euro zone money base. Hence, the primary purpose of these policies is not to increase nominal GDP or stabilise NGDP growth, but rather to change market prices. That is not monetary policy. That is credit policy and worse – it is in fact bailouts.

As the ECB’s OMT and Fed’s QE2 to a large extent have been focused on changing relative prices in the financial markets they can rightly be – and should be – criticized for leading to moral hazard. When the ECB artificially keeps for example Spanish government bond yields from increasing above a certain level then the ECB clearly is encouraging excessive risk taking. Spanish bond yields have been rising during the Great Recession because investors rightly have been fearing a Spanish government default. This is an entirely rational reaction by investors to a sharp deterioration of the outlook for the Spanish economy. Obviously if the ECB curb the rise in Spanish bond yields the ECB are telling investors to disregard these credit risks. This clearly is moral hazard.

The problem here is that a monetary authority – the ECB – is engaged in something that is not monetary policy, but people will not surprisingly think of what a central bank do as monetary policy, but the ECB’s attempts to distort relative prices in the financial markets have very little to do with monetary policy as it do not lead to a change in the money base or to a change in the expectation for future changes in the money base.

That is not to say that the ECB’s credit policies do not have monetary impact. They likely have. Hence, it is clear that the so-called OMT has reduced financial distress in the euro zone, which likely have increased the money-multiplier and money-velocity in the euro zone, but it has also (significantly?) increased moral hazard problems. So the paradox here is that the ECB really has done very little to ease monetary policy, but a lot to increase moral hazard problems.

Unfortunately many of those policy makers who rightly are very fearful of moral hazard – normally Northern European policy makers – fail to realise the difference between monetary policy and credit policy. German, Finnish and Dutch policy makers are right in opposing a credit based bailout of South European “sinners”, but they are equally wrong in opposing an monetary expansion.

The paradox here is that Northern European policy markets by opposing monetary easing in the euro zone actually are increasing the problem with moral hazard and bailouts. Hence, when monetary policy is too tight nominal GDP (and likely also real GDP) collapses. As a result debt ratios increase – and this goes for both private and public debt. That will cause both sovereign debt crisis and banking crisis, which is perceived to threaten the future of the euro. The threat to the future of the euro so far has convinced Northern European policy makers to going along with bailouts and implicit and explicit guarantees to banks and countries around the euro zone. Hence, the ECB’s overly tight monetary policy likely have INCREASED moral hazard problems.

Europe needs to return to a system where insolvent banks and countries are allowed to default. We need to end the bailouts. The Northern Europeans are completely right about that. However, we also need to end the deflationary policies of the ECB, which greatly increases public debt and banking problems.

It is certainly not given that even if the ECB brought the NGDP level back to the pre-crisis trend everything would be fine. I am fairly convinced that the removal of implicit and explicit guarantees would force banks and countries to deleverage further.  Moral hazard problems and bailouts have led to excessive risk taking. There is no doubt about that, but if the ECB (and the Fed!) focuses on maintaining nominal stability we can get an orderly return to a market based financial system where credit risks are correctly priced.

And finally solvency problems should not be dealt with through monetary or credit policy. If a country is insolvent then the only answer is an orderly debt restructuring. Similarly if banks are insolvent orderly bank resolution is needed. Monetary policy at the same time should ensure that bank resolution and debt restructuring do not lead to a negative shock to monetary conditions. The best way to do that is to keep NGDP on track.

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Update: This is a greeting to the University of Chicago Monetary Policy Reading Group. This week the group is reading and discussing Ben Bernanke’s classic 1983 paper “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”. In this paper Bernanke discusses his creditist view of the Great Depression. I believe that  these views are what led the Bernanke Fed to initially response to the Great Depression with credit policies (trying to “fix” the banks) rather than through a focused increase in the money base and the money supply.

My challenge to the UoC Monetary Policy Reading Group they should discuss how Fed policy has evolved from initially to be strongly focused on credit policies (QE2) to moving towards a monetary expansion (the Bernanke-Evans rule) and comparing the Bank of Japan’s new policy which is much more focused on an expansion of the money base rather than an attempt to distort relative prices in the financial markets. This is Friedman versus Bernanke.

“Fragile by design” – the political causes of banking crisis

Charles Calomiris undoubtedly is one of the leading experts on banking crisis in the world. Calomiris has a new book coming out – co-authored with Stephen Haber. The main thesis in the book – “Fragile by Design: Banking Crises, Scarce Credit,and Political Bargains” – is that banking crisis is not an inherent characteristic of a free-market financial system, but rather the outcome of what Calomiris and Haber terms the “Game of Bank Bargains” between the government and special interests and how this game lead to different incentives for excessive risk taking or not.

For natural reasons I have not read the book yet, but in a couple of recent papers and presentations by Calomiris and Haber have spelled out the main ideas of the book (See for example here, here, here and here). I find their large survey of history of banking crisis tremendously interesting and I find it particularly interesting that Calomiris and Haber conclude that the root cause of banking crisis has to be found in what political institutions different countries have. Said in another way the main cause banking crisis is one of “political design”.

One of the main views of Calomiris and Haber is that some countries are a lot more prone to banking crisis than other. Calomiris and Haber list the following countries as particularly prone to banking crisis: Argentina, the Democratic Republic of the Congo, Chad, the Central African Republic, Cameroon, Guinea, Kenya, the Philippines, Nicaragua, Brazil, Bolivia, Costa Rica, Thailand, Mexico, Ecuador, Colombia, Uruguay, Chile, Turkey, Spain, Sweden and the United States.

Similarly Calomiris and Haber list a number of countries that in general have been crisis free (despite abundant credit):  Bahamas, Malta, Cyprus, Brunei, Singapore, Hong Kong, Macao, South Africa, Italy, Austria, New Zealand, Australia, and Canada.

The differences between USA and Canada seem to be particularly interesting (discussed in Chapter six of the book). Hence, since 1840 the US have had 14 banking crisis, while Canada have had none and this despite of the fact that credit have been as abundant in Canada as in the US. While the two countries have the a very similar cultural and colonial  history the political institutions in Canada and the USA are very different. These differences in political institutions according to Calomiris and the US have lead to the development of vastly different banking systems in the two countries – “branch banking” in Canada and “unit banking” in the US.

There are a lot more in the book than what I have discussed above and the papers that Haber and Calomiris already have put out are extremely interesting and insightful so I can’t wait to read the book! The book unfortunately is not available on Amazon yet so I haven’t ordered it yet, but I hope that that will soon change.

PS If there is one thing that seems to be missing in Calomiris and Haber’s discussion of the causes of banking crisis then it is a discussion of monetary policy regimes. That is unfortunate in my opinion as there is no doubt that monetary policy failure has played a huge role in the present crisis and in historical crises – something I know at least Calomiris acknowledges.

Update: Charles Calomiris has informed me that “Fragile by Design” also include a discussion of monetary policy regime – for example in the case of Brazil.

Update 2: Here is an recent interview with Charles on Bloomberg TV.

Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

Chain of events in the boom-bust

In my recent post on “boom, bust and bubbles” I tried to sketch a monetary theory of bubbles. In this post I try to give an overview of what in my view seems to be the normal chain of events in boom-bust and in the formation of bubbles. This is not a theory, but rather what I consider to be some empirical regularities in the formation and bursting of bubbles – and the common policy mistakes made by central banks and governments.

Here is the story…

Chain of events in the boom-bust

- Positive supply shocks – often due to structural reforms that include supply side reforms and monetary stabilisation

- Supply side reforms leads to “supply deflation” – headline inflation drops both as a result of monetary stabiliisation and supply deflation. Real GDP growth picks up

- First policy mistake: The drop in headline inflation leads the central bank to ease monetary policy (in a fixed exchange rate regime this happens “automatically”)

- Relative inflation: Demand inflation increases sharply versus supply inflation – this is often is visible in for example sharply rising property prices and a “profit bubble”

- Investors jump on the good story – fears are dismissed often on the background of some implicit guarantees – moral hazard problems are visible

- More signs of trouble: The positive supply shock starts to ease off – headline inflation increases due to higher “supply inflation”

- Forward-looking investors start to worry about the boom turning into a bust when monetary policy will be tightened

- Second policy mistake: Cheerleading policy makers dismisses fears of boom-bust and as a result they get behind the curve on events to come and encourage investors to jump on the bandwagon

- In a fixed exchange rate the exit of worried investors effectively lead to a tightening of monetary conditions as the specie-flow mechanism sharply reduces the money supply

- The bubble bursts: Demand inflation drops sharply – this will often be mostly visible in a collapse in property prices

- The drop in demand inflation triggers financial distress – money velocity drops and triggers a further tightening of monetary conditions

- Third policy mistake: Policy makers realise that they made a mistake and now try to undo it “in hindsight” not realising that the setting has changed. Monetary conditions has already been tightened.

- Secondary deflation hits. Demand prices and NGDP drops below the pre-boom trend. Real GDP drops strongly, unemployment spikes

- Forth policy mistake: Monetary policy is kept tight – often because a fixed exchange rate regime is defended or because the central bank believes that monetary policy already is loose because interest rates are low

- A “forced” balance sheet recession takes place (it is NOT a Austrian style balance sheet recession…) – overly tight monetary policy forces investors and households through an unnecessary Fisherian debt-deflation

- Real GDP growth remains lackluster despite the initial financial distress easing. This is NOT due to an unavoidable deleveraging, but is a result of too tight monetary policy, but also because the positive supply shock that sat the entire process in motion has eased off.

-The country emerges from crisis when prices and wages have adjusted down or more likely when monetary policy finally is ease – for fixed exchange rate countries when the peg is given up

“Monetary Policy, Financial Stability, and the Distribution of Risk”

I have recently been giving a lot of attention to the work of David Eagle and his Arrow-Debreu based analysis of monetary policy rules. This is because I think David’s work provides a microfoundation for Market Monetarism and adds new dimensions to the discussion about NGDP targeting – particularly in regard to financial stability.

I have now come across a paper that is using a similar model as David’s model. However, this might be a slightly more interesting for the conspiratorial types as this paper is written by a Federal Reserve economist – Evan F. Koeing of the Federal Reserve Bank of Dallas.

Here is that abstract of Koeing’s paper “Monetary Policy, Financial Stability, and the Distribution of Risk”:

“In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal- income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.”

This paper obviously is highly relevant and as the euro crisis just keeps getting worse day-by-day we can always hope that some influential European policy makers read this paper.

After all the euro crisis is mostly a monetary crisis rather than a fiscal crisis – which David Beckworth forcefully demonstrates in a recent comment.

HT Arash Molavi Vasséi

“Global Banking Glut and Loan Risk Premium”

David Levey has sent me a new paper by Princeton University economics professor Hyun Song Shin on “Global Banking Glut and Loan Risk Premium“. I have unfortunately not had the time to read the paper yet, but it looks quite interesting and I would like to share it with my readers.

Here is the abstract:

“European global banks intermediating US dollar funds are important in influencing credit conditions in the United States. US dollar-denominated assets of banks outside the US are comparable in size to the total assets of the US commercial bank sector, but the large gross cross-border positions are masked by the netting out of the gross assets and liabilities. As a consequence, current account imbalances do not reflect the influence of gross capital flows on US financial conditions. This paper pieces together evidence from a global flow of funds analysis, and develops a theoretical model linking global banks and US loan risk premiums. The culprit for the easy credit conditions in the United States up to 2007 may have been the “Global Banking Glut” rather than the “Global Savings Glut””

Overall, I think the global financial linkages are extremely important in understanding how the Great Recession has played out and Hyun Song Shin’s paper could help us understand these linkages. I am personally very interested in the impact of the European banking sector’s demand for dollar.

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PS While the European crisis continues relentlessly it is hard to find anything positive of cheer you up. However, my colleague Antero Atilla – who long ago has realised that I am obsessed with monetary policy suggested a more fun youtube link today…have a look – it is all about money!

PPS The European crisis, business traveling and a bad flu is likely to keep me a bit away from blogging in the coming days.

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