Calomiris on “Contagious Events”

As we minute by minute are inching closer to the announcement of some form of restructuring/write-down of Greek Sovereign debt nervous investors focus on the risk of contagion from the Greek crisis to other European economies and contagion in the European banking sector.

In a paper from 2007 Charles Calomiris has a good and interesting discussion of what he calls “Contagious events”.

Here is the abstract:

“Bank failures during banking crises, in theory, can result either from unwarranted depositor withdrawals during events characterized by contagion or panic, or as the result of fundamental bank insolvency. Various views of contagion are described and compared to historical evidence from banking crises, with special emphasis on the U.S. experience during and prior to the Great Depression. Panics or “contagion” played a small role in bank failure, during or before the Great Depression-era distress. Ironically, the government safety net, which was designed to forestall the (overestimated) risks of contagion, seems to have become the primary source of systemic instability in banking in the current era.”

WARNING: If you are looking for a justification for bailouts you will probably not find it in this paper, but you will find some interesting “advise” on banking regulation.


Guest blog: Central banking – between planning and rules

I have asked Alex Salter to give his perspective on the ongoing debate about “Central banking is (not) central planning” in the blogosphere.

David Glasner also has a new comment on the subject.

But back to Alex…


Guest blog:  Central banking – between planning and rules

Alex Salter

I’ve been reading about the central banking vs. central planning debate on the blogosphere; the more I think about it the more interesting it becomes. Whether central banking is a form of central planning depends on what exactly the central bank does.  There are two broad scenarios.  In the first, the central bank is following some sort of rule or trying to hit a target.  This can be a Taylor rule, inflation target, NGDP level target, or anything else.  In this case the central bank is trying to provide a stable economic setting so that individuals can effectively engage in the market process.  If this is what the central bank is doing, I don’t think it makes sense to call it central planning. All the central bank is trying to do is lay down the “ground rules” for economic behavior. If this is central planning, you could just as easily say any institution such as property rights or the rule of law is central planning too. This obviously isn’t a useful definition of central planning!

However, a central bank may be engaging in a type of central planning if it tries to bring about a specific allocation of resources.  For example, if the central bank thinks equities prices should be higher for some reason, and they start purchasing equities, you could make an argument that this is a type of central planning.  If the central bank explicitly tries to monetize the debt and acts as an enabler for the nation’s treasury department, you could also say this is a form of central planning.  It’s still not 100% clear, since presumably the central bank is not using coercion or the threat of coercion to get market participants to behave in the way it wants; there’s voluntary assent on the other side of the agreement, even if that voluntary assent is a response to warped incentives.

In closing: if a central bank is trying to create a specific framework in which agents can operate, it’s not central planning, it’s rule setting.  If on the other hand the central bank is trying to allocate specific resources, it may be a form of central planning.  In either scenario, the usual knowledge and incentive problems still apply.

Central banks cannot ”do nothing”

Central banks cannot ”do nothing” 

Some commentators have suggested that central banks should ”do nothing” in the present crisis, but even though that on the surface sounds appealing it is in fact nonsense to say a central bank should do nothing. Central banks in fact cannot “do nothing”. Let me explain why.

The first thing to ask is what “doing nothing” means. Often people talk about monetary policy as manipulating interest rates up and down and doing nothing is taken to mean that the central bank should keep interest rates “unchanged”. However, what we really are talking about is that the central bank is intervening in the money markets to keep the price of overnight credit fixed at a given level. So imagine the demand for overnight liquidity spikes for some reason then the central bank will have to increase liquidity to keep the market interest rate from rising. Hence, even a central bank that is “doing nothing” in the sense of keeping interest rates fixed might end up doing quite a bit. Central bank credibility might reduce the need for actual intervention to keep the interest rate fixed, but that does not change the principle that ultimately the central bank will have to actively manage things.

The story is the same for a central bank that has announce a fixed exchange rate policy. Here “doing nothing” is normally taken to mean that the central bank buys and sell the currency to ensure that the exchange rate indeed remains fixed. So again “doing nothing” might involve doing quite a bit – even though again credibility might indeed reduce the need to doing something on a daily basis, but even the most credibility fixed exchange rate regimes like the Denmark’s peg to the euro or Hong Kong’s peg to the dollar from time to time (quite often in fact) would require the central banks to buy and sell their currency.

In fact all central banking involve controlling the money base. The central bank can use different operational targets like interest rates or exchange rates, but the central bank is never doing nothing. George Selgin who (indirectly) inspired this blog post would of course say that if you want central banks to do nothing then you should abolish central banking all together, but that is not the purpose of this discussion.

An example of the fallacy that a central bank can do nothing is the debate about “quantitative easing” (QE). There is really nothing special about QE as it basically just means to increase the money base. This in someway is seen to be “dirty” or dangerous and it is getting a lot of attention, but some central banks are doing QE all the time, but it is getting no attention at all. Lets say a country has a fixed exchange rate policy and the demand for its currency for some reason increases – then the central bank will have to sell it own currency to curb the strengthening of the currency. But what does it mean to “sell the currency”? In fact that means to increase the money base. That is QE. So central banks with fixed exchanges could in fact be “doing nothing” and at the same time be engaged in QE on a massive scale – just ask the good people at People’s Bank of China about that.

“Doing nothing” in monetary policy is not really as simple as it is often made up to be. There is, however, another way of looking at things and that is to differentiate between rules and discretion.

NGDP Targeting is as close to “doing nothing” as you get

After the outbreak of the Great Recession a lot of central banks have been conducting monetary policy on a discretionary basis – jumping from one crisis to another without defining the rules of engagement so to speak. An obvious example is the Federal Reserve which have implemented QE1 and QE2 and even the odd “operation twist” without bothering to state what the purpose of these policies are and under which circumstances to scale them up and down. Interestingly enough the Fed has been criticised for doing what central banks do – “playing around” with the money base – but there has been little criticism the discretionary fashion in which US monetary policy has been conducted. Even most of the Market Monetarist bloggers have failed in clearly stating this (sorry guys…).

Imagine instead that there had been a NGDP level target in place in the US when the Great Recession started. A NGDP target would have been a clear rule for the conduct of US monetary policy. It would have stated that if NGDP expectations (either market expectations or the Fed’s own forecast) drops below a certain target then the Fed should take actions to increase the money base (without any restrictions) until NGDP expectations had returned to the target level. That likely would have led to a significant increase in the money base, but within a very clearly defined framework and the increase in the money base would have been completely automatic (as would have been the “exit” from the boost in the money base). Very likely there would not have been any debate about whether this increase in the money base or not if the NGDP target framework had been in place. In fact the Fed could have said it was “doing nothing” – even though that would as demonstrated above, but it would not have done anything discretionary. The real problem with QE is not that the money base is increase, but that is done in a completely random fashion without any clear framework. So the best thing the Fed could do was to very soon implement some rules of engagement – preferably a market based NGDP level target.

PS Those of my reader who are in favour of a true gold standard should know that the central bank can easily end of doing quite a bit of manipulation of the money base within the framework of a gold standard.

PPS Just came to think of it – why did nobody debate the increase in the US money base prior to Y2K (that was actually quite insane a policy) or after 911?

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