The Peltzman effect and banking regulation

I like to tell people that I prefer taxis where the driver is not wearing a seatbelt. This mostly confuses people – at least non-economists – because the general perception is that people who do not wear seatbelts are more “irresponsible”.

However, if you know about the so-called Peltzman effect you would not be surprised by my preference of “irresponsible” taxi drivers. The Peltzman effect is named after Chicago economist Sam Peltzman.

In a very controversial article – “The Effects of Automobile Safety Regulation” – in the Journal of Political Economy from 1975 Peltzman showed that contrary to what should have expected the introduction of seat belt laws in the US did not reduce the total number death accidents in traffic.

Here Russ Robert (in a blog post from 2006) explains Peltzman’s results:

“Peltzman argued that mandatory safety devices such as seat belts reduced the probability of harm to the driver if the car crashed. That in turn would encourage people to drive more recklessly. The effect on the number of deaths was an empirical question. Which effect would be larger—the harm from the increase in the number of accidents or the reduction in harm when an accident occurred?

Holding other factors constant that might change the number of accidents (and this is never easy but he did the best he could with the data at hand), Sam found that mandatory seat belts did indeed cause more accidents. But this effect was roughly the same as the effect in the opposite direction, that accidents were less harmful. So the net number of fatalities of drivers was unaffected by the law. Sam found some evidence that the effect of the law might be to reduce driver fatalities. Unfortunately, because drivers were more reckless, there were more accidents involving pedestrians and cyclists. So their death rate due to cars increased. Total deaths were unchanged.”

It is obviously that such considerations are not only relevant for road safety. In fact we should be aware of Peltzman effects in all forms of regulation. And that particularly seems to be the case for financial regulation.

Hence, what does it for example mean when we introduce deposit insurance schemes to reduce to reduce “risks” in the financial sector. Well, following the logic of the Peltzman effect deposit insurance might reduce of bank runs (“drivers being killed”), but it will also make both bank owners and depositors take bigger risks. In fact depositors would tend to prefer more risky banks because the downside is limited by the deposit insurance if the bank collapses while banks, which take larger risks will be able to pay higher interest rates on deposits.

This would also mean that the introduction of deposit insurance schemes is likely to lower the amount of capital banks chose to hold. This is exactly what Sam Peltzman is arguing a great lecture from 2011, which I stumbled upon while searching YouTube for stuff on the Peltzman effect. Take a look here. Peltzman’s account of the development in banking regulation in the US since the Great Depression is fascinating stuff.

Peltzman spelled out similar argues in his 1970 article “Capital Investment in Commercial Banking and Its Relation to Portfolio Regulation” (also from the Journal of Political Economy), in which he also demonstrates that capital ratio did indeed drop significantly in the US after the introduction of deposit insurance.

Anybody who doubt that such a Peltzman effect exists in financial regulation should study how the Icelandic banks prior to the Icelandic collapse in 2008 set-up internet based bank in countries with generous deposit insurance schemes.

PS Gordon Tulluck came up with what I believe is the best safety device for cars – a spike attached to the steering wheel (I got this example from David Friedman’s fantastic book “Hidden Order”.)

PPS I should stress that just because deposit insurance likely leads to more risk taking and lower capital ratio it still could be desirable regulation and proponents of deposit insurance will undoubtedly point to the fact that deposit insurance led to sharp drop in bank run episodes in the US after it was introduced in 1930s. Hence, it is a trade-off, which policy makers have to be aware of.

HT Blake Johnson

It is time to stop worrying about austerity – also in the UK

I have a piece in City AM today on the impact of fiscal austerity in the UK:

FIVE years ago, nearly every macroeconomist agreed that central banks determined aggregate demand (total spending in the economy), and that fiscal stimulus was therefore unnecessary to lift depressed economies. Conversely, fiscal austerity was seen as irrelevant at best for overall growth; any impact of austerity on demand can be offset by the right monetary policy – though tax cuts could, of course, boost aggregate supply.

But the age-old discussion about the relation of fiscal policy to growth has resurfaced. Keynesian economists – including Òscar Jordà and Alan M Taylor in a paper just released by the National Bureau of Economic Research – claim that government austerity is to blame for lacklustre UK growth since 2010.

There are technical issues with the paper that make Taylor and Jordà’s precise numbers hard to evaluate. And as the economist David B Smith has noted, the important question of fiscal sustainability is not even addressed. But the more fundamental issue in the whole debate is the idea of “monetary offset”.

Read the rest here.

It is time to let bygones be bygones

US bond yields continue to rise. To some this is a major risk for the global economy. However, I continue to think that there is no reason to worry about rising US bond yields – at least not from the perspective of the US economy.

Many have highligthed that the rise in US yields have been caused by the Federal Reserve’s plans to scale back quantatively easing. The fear of “tapering” is certainly a market theme and I would certainly not rule out that the tapering talk has contributed to the rise in bond yields. However, we don’t know that and a lot of other factors certainly also have contributed to the rise in yields and I do certainly not think that the recent rise in yields in itself is likely to derail the US economy. The Fed might still fail by prematurely tighten monetary conditions, but bond yields are not telling us much in that regard. Or rather if the market really feared premature monetary tightening then yields would probably have collapsed rather than continued to rise.

Back in May I wrote the following:

Greenspan was thinking that the Federal Reserve should (or actually did) target NGDP growth of 4.5%. Furthermore, he (indirectly) said that that would correspond to 30-year US Treasury yields being around 5.5%.

This is more or less also what we had all through the Great Moderation – or rather both 5% 30-year yields and 5% NGDP growth. However, the story is different today. While, NGDP growth expectations for the next 1-2 years are around 4-5% (ish) 30-year bond yields are around 3.3%. This in my view is a pretty good illustration that while the US economy is in recovery market participants remain very doubtful that we are about to return to a New Great Moderation of stable 5% NGDP growth.

That said, with yields continuing to rise faster than the acceleration in NGDP growth we can say that we are seeing a gradual return to something more like the Great Moderation. That obviously is great news.

In fact I would argue that when US 30-year hopefully again soon hit 5% then I think that we at that time will have to conclude that the Great Recession finally has come to an end. Last time US 30-year yields were at 5% was in the last year of the Great Moderation – 2007.

We are still very far away from 5% yields, but we are getting closer than we have been for a very long time – thanks to the fed’s change of policy regime in September last year.

Finally, when US 30-year bond yields hit 5% I will stop calling for US monetary easing. I will, however, not stop calling for a proper transparent and rule-based NGDP level targeting regime before we get that.

Since then US yields have continued to rise and even though 30-year yields are still someway away from 5% we getting closer on another measure, which is probably more relavant. Take a look at the graph below.

30yearyield

This is the market expectation for 30-year yields in five years. Since May we have seen a more 100bp increase in yields and we are now closing in on my “target” of 5%.

Historically there has been a very close relationship between nominal GDP growth and 30 year yields and it is reasonable to assume that when the market is expecting close to 5% yields in five years then it is a pretty strong indication that the market no longer expects a “Japanese scenario” of 10-15 years of deflation and no NGDP growth. In fact the market now more or less seem to expect that we are heading back towards nominal GDP growth rates similarly to what we had during the Great Moderation prior to 2008. Said in another way – we have moved out of the “expectational trap”. Investors no longer see weak nominal GDP growth as a permanent situation.

Therefore, I think it is safe to conclude that we effectively are at the end of the Great Recession in terms of market expectations. That, however, do not mean that we are out of the Great Recession in terms of the macroeconomic situation. Unemployment in the US likely is well-above the structural level of unemployment and the economy is certainly not working at full capacity. But judging from the bond market we are no longer caught in an expectational trap.

Obviously even though the US economy seems to be out of the expectational trap there is no guarantee that we could not slip back into troubled waters once again. In fact as the graph above shows that in 2009  5-year ahead 30-year yields swiftly recovered back to Great Moderation levels around 5%, but then fell back to “depression levels” in 2010 and then again in 2011/12 – both times seemingly driven primarily by the euro crisis.

It should, however, be stressed that the set-backs in 2010 and 2011/2012 happened at a time when the Fed had not clearly defined a monetary policy rule nor had the Fed defined a clear alternative monetary policy instrument to the interest rate tool. Now however, it is pretty clear to most market participants that the Fed would likely step up quantitative easing if shock would hit US aggregate demand and it is fairly clear that the Fed has become comfortable with using the money base as a policy instrument. The Evans rule is far from perfect, but it is certainly better than what we had in 2010 or 2011.

In that regard it is notable that yields started the  up-trend around September last year then the Fed basically announced the Evans rule, cf. the graph above. It is also notable that there probably has been a “recognition lag” – the markets did not immediately priced in 4-5% future NGDP growth. This has only happened gradually (indicating the Fed did not explain its target well enough), but we now seem to be quite close to having fully priced in longer-term growth rates in NGDP similar to what we had during the Great Moderation.

And finally, I must admit that I increasingly think – and most of my Market Monetarist blogging friends will likely disagree – that the need for a Rooseveltian style monetary positive shock to the US economy is fairly small as expectations now generally have adjusted to long-term NGDP growth rates around 4-5%. So while additional monetary stimulus very likely would “work” and might even be warranted I have much bigger concerns than the lack of additional monetary “stimulus”.

Hence, the focus of the Fed should not be to lift NGDP by X% more or less in a one-off positive shock. Instead the Fed should be completely focused on defining its monetary policy rule. A proper rule would be to target of 4-5% NGDP growth – level targeting from the present level of NGDP. In that sense I now favour to let bygones to be bygones as expectations now seems to have more or less fully adjusted and five years have after all gone since the 2008 shock.

Therefore, it is not really meaningful to talk about bringing the NGDP level back to a rather arbitrary level (for example the pre-crisis trend level). That might have made sense a year ago when we clearly was caught in an expectations deflationary style trap, but that is not the case today. For Market Monetarists it was never about “monetary stimulus”, but rather about ensuring a rule based monetary policy.  Market Monetarists are not “doves” (or “hawks”). These terms are only fitting for people who like discretionary monetary policies.

PS Just because I now argue that we should let bygones be bygones I certainly do not plan to let the Fed of the hook. Rather the opposite, but my concern is not that monetary policy is too tight in the US. My concern is that monetary policy still is far too discretionary.

PPS If the Fed once again “slips” and let monetary conditions become excessively tight as in 2011/12 I would certainly scream about that.

PPPS My worries that Larry Summers might become the next Fed chairman certain have influenced my thinking about these issues. I don’t fear that Summers will be too hawkish or too dovish. I fear that we will go back to an ultra-discretionary monetary policy in the US. The result of this could be catastrophic.

There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

It is now very clear that what Milton Friedman advocated the Bank of Japan should do back in the mid-1990s – to expand the money base to get Japan out of deflation – is in fact working. Nominal spending growth is accelerating and with it deflation has come to an end and real GDP growth is fairly robust.

However, some have been arguing the success of Abenomics will be short-lived and that the planned increases in the Japanese sales tax might send Japan back into recession. In other words Japan is facing a fiscal cliff.

In this post I will argue that like in the case of the 2013-US fiscal cliff the fears of the negative impact of fiscal consolidation is overblown and that the risk of recession in Japan is very small if the Bank of Japan keeps doing its job and try to get inflation expectations back to 2%. It is yet another illustration of the Sumner Critique.

All we need is the AS-AD framework

I think it is pretty easy to illustrate the impact of a sales tax increase in a world with a central bank with a credible inflation target within a simple AS-AD framework.

We start out with a Cowen-Tabarrok style AS-AD framework. We use growth rates rather levels and aggregate demand curve is given by the equation of exchange (mv=py).

The graph below is our starting point.

AS AD

We have assumed that inflation in the starting point already is at 2%. This obviously is not correct, but it does not fundamentally change the analysis of the “fiscal shock”.

Japan’s sales tax will be raised to 8 percent from 5 percent in April and to 10 percent in October 2015, but here we just assume it is one fiscal shock. Again that is not important for the conclusions.

A negative fiscal shock in a Cowen-Tabarrok style AS-AD framework is basically a negative shock to money velocity (v), which will push the AD curve to the left as nominal spending drops.

However, as it is clear from the graph this will initially push inflation below the Bank of Japan’s 2% inflation target. We are here ignoring headline inflation will increase, but we are here focusing on core inflation as is the BoJ. Core inflation will drop as illustrated in the graph below.

inflation target BoJ ASAD

If the Bank of Japan is serious about its inflation target it will respond to any demand-driven drop in inflation by counteracting that with an one-to-one increase in the money base to bring back inflation to 2%.

The consequence of BoJ’s 2% inflation is hence that there will be full monetary offset of the negative fiscal shock and as a consequence inflation should broadly speaking remain unchanged at 2% and real GDP growth will be unaffected. Hence, under a credible inflation target the fiscal multiplier is zero. As in the case of the US there will be no fiscal cliff. There will be fiscal consolidation but not a negative impact on growth.

This of course does not mean that the fiscal shock will not have any impact on the Japanese economy or markets. It very likely will. It is for example clear that if the markets expect the BoJ to step up asset purchases (increase money base growth) in response to fiscal tightening then that would likely weaken the yen further. Something Japanese exporters likely will be happy about. As a consequence the sales tax hikes will likely change the composition of growth in Japan.

Finally, it should be noted that everybody in Japan is fully aware of the miserable state of public finances and as a result it is hardly a surprise to Japanese households that the government sooner or later would have to do something to improve public finances. In fact the sales tax hike was announced long ago. Therefore, we should expect some Ricardian equivalence effects to come into play here – an increase net government saving is likely to reduce net private savings. So even with no monetary offset there is likely to be some Ricardian offset. That in my view, however, is significantly less important than the monetary policy offset.

How aggressive will the BoJ have to be to offset the fiscal shock?

A crucial question of course will be how much additional monetary easing is needed to offset the fiscal shock. Here the credibility of the BoJ’s inflation comes into play.

If the BoJ’s inflation target was 100% credible we could actually argue that the BoJ would not have to increase the money base at all. The Chuck Norris effect would take care of everything.

Hence, if everybody knows that the BoJ always will ensure that inflation (and inflation expectations) is at 2% then when a fiscal shock is announced the markets will realize that that means that the BoJ will ease monetary policy. Easier monetary policy will push up stock prices and weaken the yen. That will in itself stimulate aggregate demand. In fact stock prices will continue to rise and the yen will continue to weaken until the markets are “satisfied” that inflation expectations remain at 2%.

In fact this might exactly be what is happening. The yen has generally continued to weaken and the Japanese stock markets have been holding up quite well even through the latest round of turmoil – Fed tapering fears, Syria, Emerging Markets worries etc.

But obviously, the BoJ’s inflation target is not entirely credible and inflation expectations are still well-below 2% so my guess would be that the BoJ might have to step up quantitative easing, but it is certainly not given. In fact the Japanese recovery is showing no signs of slowing down and inflation – both headline and core – continues to inch up.

A golden opportunity for the BoJ to increase credibility

Hence, I am not really worried about the planned sales tax hikes. I don’t like taxes, but I don’t think a sales tax hike will kill the Japanese recovery. In fact I believe that the sales tax hikes are a golden opportunity for the Bank of Japan to once and for all to demonstrate that it is serious about its 2% inflation.

The easiest way to do that is basically to copy a quite interesting note from the Reserve Bank of New Zealand on “Fiscal and Monetary Coordination”. This is from the note:

“…the Reserve Bank, therefore, is required to respond to developments in the economy – including changes in fiscal policy – that have material implications for the achievement of the price stability target;”

And further it says:

“These… features mean that monetary and fiscal policy co-ordination occurs through the Reserve Bank taking fiscal policy into account as an element of the environment in which monetary policy operates. This approach is to be contrasted with approaches to co-ordination that involve joint determination of monetary policy by the monetary and fiscal policy agencies.”

And finally:

“While demand – and thus inflation – pressures may originate from a range of different sources, the task of monetary policy is to respond so as to maintain an overall level of demand consistent with keeping inflation in one to two years’ time within the target range. For example, if the government increases its net spending, all other things being equal, monetary policy needs to be tighter for a time, so as to slow growth of private demand and “make room” for the additional government spending.”

If the BoJ copied this note/statement then it basically would be an open-ended commitment to offset any fiscal shock to aggregate demand – and hence to inflation – whether positive or negative.

By telling the market this the Bank of Japan would do a lot to reduce the worries among some market participants that the BoJ might not be serious about ensuring that its 2% inflation target will be fulfilled even if fiscal policy is tightened.

So far BoJ governor Kuroda has done a good job in managing expectations and so far all indications are that his policies are working – deflation seems to have been defeated and growth is picking up.

If Kuroda keeps his commitment to the 2% inflation target and stick to his rule-based monetary policy and strengthens his communication policies further by stressing the relationship between monetary policy and fiscal policy – RBNZ style – then there is a good chance that the planed sales tax hikes will not be a fiscal cliff.

Happy Entrepreneur Day

I see a lot of people in the US have been happy to declare yesterday labor AND capital day (See for example Mark Perry at the American Enterprise Institute here). The argument is that you not only need labour to produce, but you equally need capital. That is all fine – even though I think it is a bit childish. For most Americans labor day is a just another holiday with no political significance. Celebrating the role of labour in the economy does not mean Americans think less of capitalists after all most Americans deep down fully well know that capital is at least as important as labour in the production of goods and services.

That said, if you really want to celebrate anything it is neither labour nor capital, but rather the entrepreneur as any fan of Joseph Schumpeter and Israel Kirzner would tell you.

The real difference between a communist or nazi command economy and a free capitalist economy is not the lack of capital in a command economy. After all capital is just accumulation of savings. Command economies can easily produce capital. Stalinist Russia or Nazi Germany are good examples of this.

The entrepreneur – the most underappreciated factor of production 

What command economies cannot do is to unleash the entrepreneurial spirits that you have in capitalist economies. The role of the entreprenur is hugely underappreciated in modern economics.

To me the entrepreneur has two key roles in a capitalist economy.

First, the entrepreneur roots out misallocation of the system – the entrepreneur is the equilibrating force in the economy. He plays the role of the Walrasian auctioneer in the sense he buys cheap and sells expensive and that ensure the markets clear – it is all about arbitrage. Without the entrepreneur we would need the communist bureaucrat to ensure that “markets” would clear.

Adam Smith’s famous butcher both provided capital and labour, but most importantly he was the entrepreneur who spotted the need for meat and provided that to the consumers. Not because he loved the consumers, but because of his love for profit (not confuse with the rent on capital).

The entrepreneur is the economic agent who brings consumer, labour and capital together. When we try to live without the entrepreneur we get misallocation and economic disaster.

Second, the entrepreneur has the role of the inventor. The Steve Jobs and Graham Bell of the world. The people with ideas. There is no room for these people in command economies. They flourish in capitalist economies to the great benefit of themselves, consumers, laborers and capitalists.

But hadn’t it been for great economists like Israel Kirzner the most important agent in the capitalist economy would have been totally unappreciated.

So let the political pundits celebrate labor and capital day on the first Monday of September, but let at least the economists celebrate Entrepreneur Day on the first Tuesday of September.

Happy Entrepreneur Day! 

PS Entrepreneurs would be the last people in the world to take the day off on Entrepreneur Day.

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.

%d bloggers like this: