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.

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Firefighter Arsonists – the myth of the central bankers as ‘good’ crisis managers

The recent debate about who should be the new Federal Reserve governor has made me think about the general misperception that a good central bank governor is a good “crisis manager”.

This is for example Ezra Klein endorsing Larry Summer for new Fed chief:

Summers knows how to manage a crisis. This White House is particularly attuned to the idea that the economy can fall apart at any moment. Summers, they think, knows what to do when that happens. He was at the center of the Clinton administration’s efforts to fight back the various emerging-markets crises of the 1990s (remember “The Committee to Save the World”?). He was core to the Obama administration’s efforts to fight the financial crisis in 2009 and 2010. Few people on earth are as experienced at dealing with financial crises — both of the domestic and international variety — as Summers.
What is wrong with this argument?

First, of all the assumption is that crisis is a result of the market economy’s inherent instability and that the regulators’ and the central bankers’ role is to somehow correct these failures. There is no doubt that central bankers like this image as saviours of the world. However, history shows that again and again we are in fact talking about firefighter arsonists – central banks again and again have caused crisis and afterwards been hailed as the firefighters who flew in and saved the world.

Just take the ECB’s actions of the last couple of years. The introduction of the so-called OMT program is often said to have ended the fire that was (is) the euro zone crisis. But why did we have a euro crisis to begin with? Well, it is pretty hard to get around fact that the ECB’s two rate hikes in 2011 played a very significant role in igniting the crisis in the first place. So is the ECB a firefighter or an arsonist?

Second, describing central bankers as crisis managers and firefighters exactly defines monetary policy as first of all a highly discretionary discipline. There are no rules to follow. A crisis suddenly erupts and the clever and imaginative crisis manager – a Larry Summers style person – flies in and saves the day. This is often done with the introduction of enormous amounts of moral hazard into the global financial system.  This has certainly been the case during the Great Recession and it was certainly also the case when Summers was on “The Committee to Save the World”.

committee-to-save-the-world-303x400

Did the “The Committee to Save the World” actually save the world or did it introduce a lot more moral hazard into the global financial system?

We don’t need crisis managers – we need strict and predictable monetary policy rules

We need to stop thinking of central bankers as crisis managers. They are not crisis managers and to the extent they try to be crisis managers they are not necessarily good crisis managers. As long as there is a monopoly on money issuance the central bank’s role is to ensure nominal stability and act of as lender of last resort. Nothing more than that.

To the extent the central bank should play a role in a crisis it should ensure nominal stability by providing an elastic supply of money. Hence, in the event of a drop in money velocity the central bank should increase the money base to stabilize nominal GDP. Second, the central bank shall act as lender-of-last resort and provide liquidity against proper collateral. Those are the core central bank tasks. Often central banks have failed on these key roles – the Fed certainly failed on that in 2008 when the Primary Dealer system broke down and the Fed effectively failed to act as a lender-of-last resort and allowed money-velocity to collapse without increasing the money base enough to offset it.

On the other hand the Fed got involved in tasks that it should never have gotten itself into – such as bank rescue and credit policies.

A stable monetary and financial system is strictly rule based. There should be very clear rules for what tasks the central bank are undertaking and how they are doing it. The central bank’s reaction function should be clearly defined. Furthermore, bank resolution, supervision and enforcement of capital requirements etc. should also be strictly rule based.

If we have a strictly rule based monetary policy and rule-based financial regulation (for example very clearly defined norms for banking resolution) then we will strongly reduce the risk of economic and financial crisis in the first place.  That would completely eliminate the argument for central banking firefighters. Public Choice theory, however, tells us that that might not be in the interest of firefighters – because why would we need firefighters if there are not fires?

Finally let me quote Robert Hetzel’s conclusion on the Asian crisis from his book on the history of the Fed (pp 215):

“…market irrationality was not the source of the financial crisis that began in 1997. The fundamental source was the moral hazard created by the investor safety net put together by the no-fail policies of governments in emerging-market economies for their financial sectors and underwritten by the IMF credit lines. The Fed response to the Asia crisis would propagate asset market volatility by exacerbating a rise in U.S. equity markets”

Hence, the firefighters created the conditions for the Asian crisis and following stock market bubble. And we should remember that today. Because central bankers over the past five years have acted as discretionary firefighters (the Larry Summers playbook) they rather than acting within a rule based monetary policy framework might instead very well have laid the foundation for the next crisis by further increasing moral hazard problems in the global financial system. Paradoxically enough central bankers have been extremely reluctant about doing what they are meant to do – ensuring nominal stability by providing an elastic money supply – but have happily ventured into credit policies and bailouts.

PS Given the discussion some might be wrongly led to conclude that I think monetary easing is the same as moral hazard. That, however, is not the case. See a discussion of that topic here. We have had too tight monetary policy in the euro zone and the US in the past five years, but far too much credit policy and too much moral hazard.

“We refuse to let Detroit (and Egypt) go bankrupt”

The big story of the week in the US has undoubtedly been the bankruptcy of the city of Detroit. I should stress that I have next to no insight into Detroit’s fiscal situation. However, the bankruptcy is nonetheless a reminder of the risks moral hazard.

Conservative commentators has been fast to pick up on a comment from President Obama who back in October last year made the following statement:

“We refused to throw in the towel and do nothing. We refused to let Detroit go bankrupt. We bet on American workers and American ingenuity, and three years later, that bet is paying off in a big way”

This quote is of course taken completely out of context. Obama was not talking about the municipality of Detroit, but about the Detroit auto industry. So claiming that Obama in some way had promised to save Detroit from bankruptcy is not really fair. However, the quote nonetheless raises a highly relevant question of local public finances and moral hazard, which is highly relevant for not only US municipalities, but also have wider global implications as I will argue below.

The moral hazard of local government

While Obama’s comments regarding Detroit was not explicitly about the municipality they nonetheless are a pretty good illustration of the general perception about the US federal government’s willingness to bailout major US cities and US states for that matter.

By saying that he was happy to have bailed out the auto industry Obama most likely also signaled that he would be equally happy bailing out the city of Detroit. Furthermore, the fact that Detroit has been run by Democrats for decades probably also adds to investors’ expectations for some kind of Federal bailout of Detroit.

However, as I said I don’t have a lot of insight to the finances of Detroit and what I really want to discuss is the general problem of moral hazard in local government.

The key problem is that central government – in the case of the US state and federal government – will be tempted to bailout major municipalities that gets into financial distress. In US history this of course has happened numerous times. Just imagine what would happen if the mayor of a major city comes out and says “We are bankrupt so from now on there will be no public services. The police force has been sent home”. If that happened it would put tremendous political pressure on state and federal government to “solve” the problem.

And this is really the problem in terms of local government funding. Investors know that they to some extent can rely on state and federal government to step-in and save the municipality even if it has been grossly financially irresponsible. As a consequence the financial markets will tend to significantly mis-price the risk of a default. This is, however, not market failure, but rather government failure. At the core of the problem is that investors rationally expect local government to be bailed out by either state or federal government. It might or might not happen, but just the fact that there is a certain probability that this will happen will lead to a mis-pricing of the default risk.

This means that the funding costs of local government will be lower than it should be to reflect the true default risk. It is not very hard to see that that will at least indirectly reward irresponsible policies. The local government will likely be politically rewarded for building a new mega stadium (a well-known local finance problem in the US) or increasing teachers salaries etc. However, the cost of bankruptcy will at least party be transferred to states and federal government. This obviously encourage irresponsible policies locally.

Did moral hazard play a role in Detroit’s economic troubles? I am not sure, but I am very sure that moral hazard has had a major negative impact on the state of the US auto industry for decades and that at least indirectly have had a serious impact on the state of city of Detroit’s finances. Anyway I am sure that the bankruptcy of Detroit will inspire aspiring young public choice economists to study the impact of moral hazard of Detroit’s bankruptcy – at least I hope so.

Since it is very hard to avoid the temptation of bailing out failed municipalities it is not surprising that in most developed countries in the world the fiscal independence of local government is restricted by more or less strict rule imposed by central government (for example balance budget rules or rules limiting the ability to raise funds through lending in the financial markets). That is also to some extent the case in the US. These “constitutional” restrictions apparently has not be effective enough to avoid the Detroit’s bankruptcy and if Detroit’s troubles should lead to any policy debate in the US – then it should be how to change the constitutional/institutional set-up for major US cities to provide lawmakers with the right incentives to ensure prudent financial manage of municipal finances. And yes, this is of course is a completely parallel discussion to the discussion of moral hazard in the banking sector.

From Detroit to Egypt

The bankruptcy of Detroit should actually also lead to a debate about US foreign aid. Yes, believe it or not there a strong parallels between the moral hazard problems in US local government finances and US foreign aid.

The recent political unrest and the military coup in Egypt has made me to think about moral hazard problems of particularly US foreign aid.

There is no doubt that US foreign aid to a large extent is driven by what the US government perceives to be US foreign policy interests – particularly security interests and this has been a key motivating factor for US aid to Egypt for decades and no one would deny that the changing Egyptian governments over the years has been reward for keeping peace with Israel – a close ally of the US.

A list of the top-five recipients of US aid clearly reveals to what extent US foreign aid is driven by geo-political concerns rather than anything else: Afghanistan, Israel, Iraq, Pakistan and Egypt. Particularly the fact that Israel – not exactly a developing country and a country  - is notable.

To argue that the key concern of US foreign aid is economic and social development is pretty in fact pretty hard. Rather it is US foreign policy interests that determines what countries, which will receive foreign. And investors of course know this. Hence, who would seriously imagine that the US government would let Israel or Egypt go bankrupt (as long as these countries act accordingly with US foreign policy interests)? And this of course is reflected in market pricing of the default risk of Israel and Egypt.

So in the same way as investors would investors could be betting on the US federal government (or state governments) to bailout major US cities then in the same way investors would rationally bet on countries like Israel or Egypt being bailout if they were to get into financial troubles. As a result we should expect financial markets to under-price the risk of a government default in for example Egypt and similarly is this is likely to make the Egyptian government less fiscally responsible. Whether or not moral hazard has been the main driver of Egyptian fiscal decisions or not is hard to say, but it remains a fact that Egyptian public finances been a mess for decades.

IMF lending and moral hazard

Does all this sound far-fetched? Not at all if you look at numerous studies of what determines for example IMF lending. The US of course is the large contributor to the IMF and the US has a major say in how IMF funds are used.

Hence, for example a very interesting paper by Axel Dreher, Jan-Egbert Sturm and James Raymond Vreeland published earlier this year shows that “political important” countries face “softer conditions” for IMF loans than politically non-important countries.

I believe that it is very likely that US foreign aid motives distort the market pricing of default risk in certain particularly Emerging Markets and as a consequence increases global moral hazard problems.

So if you think moral hazard played a role in Detroit’s bankruptcy you should also consider what role moral hazard has played in recent events in Egyptian financial markets and it is hardly a coincident that the Egyptian financial markets rallied when the anti-US Muslim Brotherhood was ousted – effectively making a new IMF loan for Egypt more likely.

PS If you want to understand what is the problem with the ECB’s OMT program then you should just think about moral hazard. And while I certainly do not think that monetary easing is not moral hazard, “credit easing” done in the way the ECB is doing it certainly is. Also see my earlier post on why monetary easing is not a bailout, but ECB style credit polices are.

Update: Jim Pethokoukis has a very good piece on National Review Online on how to revive Detroit.

The moral hazard of 3-year old boys

My three year old son Mathias had an accident in his kindergarden the other day. He fell from a tall chair and as a result hurt is lip so his mom had to take him to the emergency room.

Luckily he did not have to any stitches in his lip and he took the whole thing very well (much better than his parents). After having been to the emergency room my wife took Mathias to a toyshop to buy him a small present because he had taken the whole thing so well. He got himself a laser gun.

When I put him to bed at night we had a talk about the events of the day and as always we talked about what he was going to do the next day:

Me: “It has been a rather special day today, but what will you be doing tomorrow?”

Mathias: “I will go to the hospital!”

Me (in shock): “You are not going to the hospital – you are going to kindergarden”

Mathias: “No, I am going to hospital and then mom will buy Spiderman for me in the toyshop!”

See that is moral hazard for you!

HT Vlad

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.

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

Boom, bust and bubbles

Recently it has gotten quite a bit of attention that some investors believe that there is a bubble in the Chinese property market and we will be heading for a bust soon and the fact that I recently visited Dubai have made me think of how to explain bubbles and if there is such a thing as bubbles in the first bubbles.

I must say I have some experience with bubbles. In 2006 I co-authoured a paper on the Icelandic economy where we forecasted a bust of the Icelandic bubble – I don’t think we called it a bubble, but it was pretty clear that that is what we meant it was. And in 2007 I co-authored a number of papers calling a bust to the bubbles in certain Central and Eastern European economies – most notably the Baltic economies. While I am proud to have gotten it right – both Iceland and the Baltic States went through major economic and financial crisis – I nonetheless still feel that I am not entire sure why I got it right. I am the first to admit that there certainly quite a bit of luck involved (never underestimate the importance of luck). Things could easily have gone much different. However, I do not doubt that the fact that monetary conditions were excessive loose played a key role both in the case of Iceland and in the Baltic States. I have since come to realise that moral hazard among investors undoubtedly played a key role in these bubbles. But most of all my conclusion is that the formation of bubbles is a complicated process where a number of factors play together to lead to bubbles. At the core of these “accidents”, however, is a chain of monetary policy mistakes.

What is bubbles? And do they really exist? 

If one follows the financial media one would nearly on a daily basis hear about “bubbles” in that and that market. Hence, financial journalists clearly have a tendency to see bubbles everywhere – and so do some economists especially those of us who work in the financial sector where “airtime” is important. However, the fact is that what really could be considered as bubbles are quite rare. The fact that all the bubble-thinkers can mention the South Sea bubble or the Dutch Tulip bubble of 1637 that happened hundreds years ago is a pretty good illustration of this. If bubbles really were this common then we would have hundreds of cases to study. We don’t have that. That to me this indicates that bubbles do not form easily – they are rare and form as a consequence of a complicated process of random events that play together in a complicated unpredictable process.

I think in general that it is wrong to see any increase in assets prices that is later corrected as a bubble. Obviously investors make mistakes. We after all live in an uncertain world. Mistakes are not bubbles. We can only talk about bubbles if most investors make the same mistakes at the same time.

Economists do not have a commonly accepted description of what a bubble is and this is probably again because bubbles are so relatively rare. But let me try to give a definitions. I my view bubbles are significant economic wide misallocation of labour and capital that last for a certain period and then is followed by an unwinding of this misallocation (we could also call this boom-bust). In that sense communist Soviet Union was a major bubble. That also illustrates that distortion of  relative prices is at the centre of the description and formation of bubbles.

Below I will try to sketch a monetary based theory of bubbles – and here the word sketch is important because I am not actually sure that there really can be formulated a theory of bubbles as they are “outliers” rather than the norm in free market economies.

The starting point – good things happen

In my view the starting point for the formation of bubbles actually is that something good happens. Most examples of “bubbles” (or quasi-bubbles) we can find with economic wide impact have been in Emerging Markets. A good example is the boom in the South East Asian economies in the early 1990s or the boom in Southern Europe and Central and Eastern European during the 2000s. All these economies saw significant structural reforms combined with some kind of monetary stabilisation, but also later on boom-bust.

Take for example Latvia that became independent in 1991 after the collapse of the Soviet Union. After independence Latvia underwent serious structural reforms and the transformation from planned economy to a free market economy happened relatively fast. This lead to a massively positive supply shock. Furthermore, a quasi-currency board was implemented early on. The positive supply shock (which played out over years) and the monetary stabilisation through the currency board regime brought inflation down and (initially) under control. So the starting point for what later became a massive misallocation of resources started out with a lot of good things happening.

Monetary policy and “relative inflation”

As the stabilisation and reform phase plays out the initial problems start to emerge. The problem is that the monetary policies that initially were stabilising soon becomes destabilising and here the distinction between “demand inflation” and “supply inflation” is key (See my discussion decomposion demand and supply inflation here). Often countries in Emerging Markets with underdeveloped financial markets will choose to fix their currency to more stable country’s currency – for example the US dollar or in the old days the D-mark – but a policy of inflation targeting has also in recent years been popular.

These policies often succeed in bringing nominal stability to begin with, but because the central bank directly or indirectly target headline inflation monetary policy is eased when positive supply shocks help curb inflationary pressures. What emerges is what Austrian economists has termed “relative inflation” – while headline inflation remains “under control” demand inflation (the inflation created by monetary policy) increases while supply inflation drops or even turn into supply deflation. This is a consequence of either a fixed exchange rate policy or an inflation targeting policy where headline inflation rather than demand inflation is targeted.

My view on relative inflation has to a very large extent been influenced by George Selgin’s work – see for example George’s excellent little book “Less than zero” for a discussion of relative inflation. I think, however, that I am slightly less concerned about the dangers of relative inflation than Selgin is and I would probably stress that relative inflation alone can not explain bubbles. It is a key ingredient in the formation of bubbles, but rarely the only ingredient.

Some – George Selgin for example (see here) – would argue that there was a significant rise in relatively inflation in the US prior to 2008. I am somewhat skeptical about this as I can not find it in my own decompostion of the inflation data and NGDP did not really increase above it’s 5-5.5% trend in the period just prior to 2008. However, a better candidate for rising relative inflation having played a role in the formation of a bubble in my view is the IT-bubble in the late 1990s that finally bursted in 2001, but I am even skeptical about this. For a good discussion of this see David Beckworth innovative Ph.D. dissertation from 2003.

There are, however, much more obvious candidates. While the I do not necessarily think US monetary policy was excessively loose in terms of the US economy it might have been too loose for everybody else and the dollar’s role as a international reserve currency might very well have exported loose monetary policy to other countries. That probably – combined with policy mistakes in Europe and easy Chinese monetary policy – lead to excessive loose monetary conditions globally which added to excessive risk taking globally (including in the US).

The Latvian bubble – an illustration of the dangers of relative inflation

I have already mentioned the cases of Iceland and the Baltic States. These examples are pretty clear examples of excessive easy monetary conditions leading to boom-bust. The graph below shows my decompostion of Latvian inflation based on a Quasi-Real Price Index for Latvia.

It is very clear from the graph that Latvia demand inflation starts to pick up significantly around 2004, but headline inflation is to some extent contained by the fact that supply deflation becomes more and more clear. It is no coincidence that this happens around 2004 as that was the year Latvia joined the EU and opened its markets further to foreign competition and investments – the positive impact on the economy is visible in the form of supply deflation. However, due to Latvia’s fixed exchange rate policy the positive supply shock did not lead to a stronger currency, but rather to an increase in demand inflation. This undoubtedly was a clear reason for the extreme misallocation of capital and labour in the Latvian economy in 2005-8.

The fact that headline inflation was kept down by a positive supply shock probably help “confuse” investors and policy makers alike and it was only when the positive supply shock started to ease off in 2006-7 that investors got alarmed.

Hence, here a Selginian explanation for the boom-bust seems to be a lot more obvious than for the US.

The role of Moral Hazard - policy makers as “cheerleaders of the boom”

To me it is pretty clear that relative inflation will have to be at the centre of a monetary theory of bubbles. However, I don’t think that relative inflation alone can explain bubbles like the one we saw in the Latvia. A very important reason for this is the fact that it took so relatively long for investors to acknowledge that something wrong in the Latvian economy. Why did they not recognise it earlier? I think that moral hazard played a role. Investors full well understood that there was a serious problem with strongly rising demand inflation and misallocation of capital and labour, but at the same time it was clear that Latvia seemed to be on the direct track to euro adoption within a relatively few years (yes, that was the clear expectation in 2005-6). As a result investors bet that if something would go wrong then Latvia would probably be bailed out by the EU and/or the Nordic governments and this is in fact what happened. Hence, investors with rational expectations rightly expected a bailout of Latvia if the worst-case scenario played out.
The Latvian case is certainly not unique. Robert Hetzel has made a forcefull argument in his excellent paper “Should Increased Regulation of Bank Risk Taking Come from Regulators or from the Market?” that moral hazard played a key role in the Asian crisis. Here is Hetzel:

“In early 1995, the Treasury with the Exchange Stabilization Fund, the Fed with swap accounts, and the IMF had bailed out international investors holding Mexican Tesobonos (Mexican government debt denominated in dollars) who were fleeing a Mexico rendered unstable by political turmoil. That bailout created the assumption that the United States would intervene to prevent financial collapse in its strategic allies. Russia was included as “too nuclear” to fail. Subsequently, large banks increased dramatically their short-term lending to Indonesia, Malaysia, Thailand and South Korea. The Asia crisis emerged when the overvalued, pegged exchange rates of these countries collapsed revealing an insolvent banking system. Because of the size of the insolvencies as a fraction of the affected countries GDP, the prevailing TBTF assumption that Asian countries would bail out their banking systems suddenly disappeared.”

I would further add that I think policy makers often act as “cheerleaders of the boom” in the sense that they would dismiss warnings from analysts and market participants that something is wrong in the economy and often they are being supported by international institutions like the IMF. This clearly “helps” investors (and households) becoming more rationally ignorant or even rationally irrational about the “obvious” risks (See Bryan Caplan’s discussion of rational ignorance and rational irrationality here.)

Policy recommendation: Introduce NGDP level targeting

Yes, yes we might as well get out our hammer and say that the best way to avoid bubbles is to target the NGDP level. So why is that? Well, as I argued above a key ingredient in the creation of bubbles was relative inflation – that demand inflation rose without headline inflation increasing. With NGDP level targeting the central bank will indirectly target a level for demand prices – what I have called a Quasi-Real Price Index (QRPI). This clearly would reduce the risk of misallocation due to confusion of demand and supply shocks.

It is often argued that central banks should in some way target asset prices to avoid bubbles. The major problem with this is that it assumes that the central bank can spot bubbles that market participants fail to spot. This is further ironic as it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles. Further, if the central bank targets the NGDP level then the potential negative impact on money velocity of potential bubbles bursting will be counteracted by an increase in the money supply and hence any negative macroeconomic impact of the bubble bursting will be limited. Hence, it makes much more sense for central banks to significantly reduce the risk of bubbles by targeting the NGDP level than to trying to prick the bubbles.NGDP targeting reduces the risk of bubbles and also reduces the destabilising impact when the bubbles bursts.

Finally it goes without saying that moral hazard should be avoided, but here the solutions seems to be much harder to find and most likely involve fundamental institutional (some would argue constitutional) reforms.

But lets not worry too much about bubbles

As I stated above the bubbles are in reality rather rare and there is therefore in general no reason to worry too much about bubbles. That I think particularly is the case at the moment where overly tight monetary policy rather overly loose monetary policy. Furthermore, contrary to what some have argued the introduction – which effective in the present situation would equate monetary easing in for example the US or the euro zone – does not increase the risk of bubbles, but rather it reduces the risk of future bubbles significantly. That said, there is no doubt that the kind of bailouts that we have see of certain European governments and banks have increased the risk of moral hazard and that is certainly problematic. But again if monetary policy had follow a NGDP rule in the US and Europe the crisis would have been significantly smaller in the first place and bailouts would therefore not have been “necessary”.

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PS I started out mentioning the possible bursting of the Chinese property bubble. I have no plans to write on that topic at the moment, but have a look at two rather scary comments from Patrick Chovanec:

“China Data, Part 1A: More on Property Downturn”
“Foreign Affairs: China’s Real Estate Crash”

 

 



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