Julien Noizet on banking regulation and ‘the importance of intragroup funding’

Julien Noizet’s blog ‘Spontaneous Finance’ in my view is the best blog out there on banking issues. Julien’s blog often deals with the economic and financial impact of financial regulation. Noizet used to be a banking analyst for Fitch Rating so he surely should understands about credit risk and banking. I highly recommend to everybody interested in financial and banking regulation to follow Julien’s excellent blog.

Recently Julien has written about how financial regulation is increasing suffocating the financial sector – particularly in Europe. Julien focuses on regulatory failure and particularly new regulatory limits on ‘intragroup funding’ in international banking groups.

What makes Julien’s discussion interesting is not only that he uncovers the impact of present regulatory failure, but he also has an excellent discussion workings of different historical banking systems – Julien looks at the US, Canada and Germany and looks at what how present regulatory changes in Europe actually risk making the banking system more fragile.

Read Julien’s posts here:

Is regulation killing banking… for nothing? The importance of intragroup funding

The importance of intragroup funding – The 19th century US experience

The importance of intragroup funding – 19th century US vs. modern Germany

The importance of intragroup funding – 19th century Canada

We are presently going through a period of regulatory overkill in the European banking sector and while regulators believe that they are reducing banking risks they are likely doing the opposite. As Charlie Calomiris would say – the European banking is becoming Fragile by Design. Julien’s blog posts describes these risks very well.

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I just ran a million simulations of the World Cup – Brazil won 450,000 times

Any respectable economist should have a view on who will win the upcoming World Cup in football in Brazil. Therefore I of course also have a view on this.

I have co-authored a paper on this topic with my clever Danske Bank colleagues Jens Pedersen, Morten Thrane  Helt, Stanislava Pravdova and Kristoffer Kjær Lomholt.

This is from the paper – “Brazil set to succeed on the pitch, but it’s an uphill battle for the economy”:

 While there is not much to cheer about regarding the Brazilian economy, we believe the Brazilian population will at least be able to cheer about its national team’s result at the upcoming football World Cup.

In this document, we present our forecasts not only for the Brazilian economy but also for the outcome of the World Cup. We have estimated an econometric model for the World Cup result based on data from the five previous World Cup tournaments and used the model parameters to simulate the upcoming World Cup and the results are clear to us.

In our view, home advantage, a large population and a strong football tradition will ensure that Brazil wins the World Cup. We believe Argentina will be in the running but will lose to Brazil in the final. Germany will take third place.

However, chance is a major factor in football, so nothing is given – not even for Brazil. To describe these factors we have used so-called Monte Carlo simulations to estimate the probability of different teams winning the World Cup. Brazil is strong favourite, with our simulation indicating a 45% chance that Brazil will win the tournament. We calculate the runners up are much less likely to win, with Argentina having an 8.1% chance, Germany 7.6% and France 6.7%.

We believe Spain will be the big disappointment of the tournament and believe it is likely to exit the tournament after losing to Italy at the quarter final stage. We see only a 4% likelihood of Spain winning the 2014 World Cup.

worldcup

PS I didn’t really do the simulations – my colleagues did.

Follow me on Twitter here.

 

Hitler’s Highways and UK monetary policy – two interesting working papers

The last couple of months have been quite busy for me with a lot of traveling and particularly the Ukrainian crisis has taken a lot of time so I have not had enough time – or energy – to blog. But don’t worry – I hope that I soon will be back to getting more blog posts out every week. After all as long as we have central banks monetary policy failure is a given and I love to blog about it – even when it makes me very angry.

I had really been planing to write something about Thomas Piketty’s book Capital in the Twenty-First Century. I got it in the mail a couple of days ago, but frankly speaking I can’t really concentrate on reading the book – and I must also admit that his many references to Karl Marx does not make the book more enjoyable (to me at least).

So instead this blog post is an attempt to get over my minor writer’s block by writing a bit about two very interesting working papers I came across while sitting in Stockholm airport earlier today.

The first one is a rather brilliant application of econometrics in the study of German political-economic history. The name of paper is “Highway to Hitler” by Nico Voigtländer and Hans‐Joachim Voth.

This is the abstract:

Can infrastructure investment win “hearts and minds”? We analyze a famous case in the early stages of dictatorship – the building of the motorway network in Nazi Germany. The Autobahn was one of the most important projects of the Hitler government. It was intended to reduce unemployment, and was widely used for propaganda purposes. We examine its role in increasing support for the NS regime by analyzing new data on motorway construction and the 1934 plebiscite, which gave Hitler great powers as head of state. Our results suggest that road building was highly effective, reducing opposition to the nascent Nazi regime.

Extremely interesting…read it!

The second paper is on monetary policy – it is a working paper – The macroeconomic effects of monetary policy: a new measure for the United Kingdom – from the Bank of England by James Cloyne and Patrick Hürtgen.

Here is the abstract:

This paper estimates the effects of monetary policy on the UK economy based on a new, extensive real-time forecast data set. Employing the Romer–Romer identification approach we first construct a new measure of monetary policy innovations for the UK economy. We find that a 1 percentage point increase in the policy rate reduces output by up to 0.6% and inflation by up to 1.0 percentage point after two to three years. Our approach resolves the price puzzle for the United Kingdom and we show that forecasts are crucial for this result. Finally, we show that the response of policy after the initial innovation is crucial for interpreting estimates of the effect of monetary policy. We can then reconcile differences across empirical specifications, with the wider vector autoregression literature and between our United Kingdom results and the larger narrative estimates for the United States.

I think that the method Cloyne and Hürtgen use to study the macroeconomic impact of monetary policy shocks is exactly the right method to use. I have always had a lot of sympathy for the so-called narrative method pioneered by Christina and David Romer in 2004. Cloyne and Hürtgen’s paper is inspired by the Romers’ approach.

This is from the summary of the paper:

Identifying the effects of changes in monetary policy requires confronting at least three technical challenges. First, monetary policy instruments, interest rates, and other macroeconomic variables are determined simultaneously as policymakers both respond to macroeconomic fluctuations and intend their decisions to affect the economy. Second, policymakers are likely to react to expected future economic conditions as well as current and past information. Third, policymakers base their decisions on “real-time” data (that available at the time), not the ex-post (revised) data often used in empirical studies.

A major advantage of the Romer and Romer approach is that we can directly tackle all three of these empirical challenges. First, we need to disentangle cyclical movements in short-term market interest rates from policymakers’ intended changes in the policy target rate. A particular advantage of studying the United Kingdom is that the Bank of England’s policy rate, Bank Rate, is the intended policy target rate. We therefore do not need to construct the implied policy target  rate from central bank minutes as in Romer and Romer did. As a second step, the target rate series is purged of discretionary policy changes that were responding to information about changes in the macroeconomy. This may include real-time data and forecasts that determine the policy reaction to anticipated economic conditions.

Yes, (market) monetarists might say that we should not focus (exclusively) on interest rates, but the authors are nonetheless right to do it in the case of Bank of England as the interest rate has been the key policy “instrument” (actually an intermediate target) for the BoE in the period studied in the paper.

I think we can draw two very clear conclusions from the paper. 1) We should think of monetary policy shocks are deviations from the central banks’ announced rule/reaction function and we cannot say monetary policy is easy is interest rates are low. Monetary policy is only easy if the key policy rate is lower than what it should be according to the policy rule. 2) Monetary policy is extremely potent.

I should, however, also say I missed two things in the paper. 1) The paper only looks at the period until 2007. It would have been extremely interesting to see what happened in 2008. My expectation would be that the method used in the paper would reveal that the British economy was hit by a major negative monetary policy shock in 2008. The BoE failed. 2) I would have loved to see the method applied to “unconventional” monetary policy (I hate that term!) – has BoE continued a clearly defined rule after 2007? I think not…

Enjoy both of these rather brilliant working papers…

It is time to get government out of US housing finance

Scott Sumner has a great post on the very scary state of US housing finance. This is something that many Europeans might not realise, but when it comes to housing finance the US is likely one of the most socialist countries among the developed economies of the world.

This is from the Wall Street Journal article Scott quotes in his post:

Fannie and Freddie, which remain under U.S. conservatorship, and federal agencies continue to backstop the vast majority of new mortgages being issued.

Yes, that is true – the two largest mortgage lenders in the US is effectively government owned. So to the extent that you think that there was a bubble in US property market prior to 2008 – I am not sure that there was – then you should probably forget the talk about overly easy monetary policy and instead focus on the massive US government involvement in housing finance.

Post-2008 the regulatory move has been to tighten lending standards for mortgage lenders, but now we have this (also from the WSJ article):

The Obama administration and federal regulators are reversing course on some of the biggest post crisis efforts to tighten mortgage-lending standards amid concern they could snuff out the fledgling housing rebound and dent the economic recovery.

On Tuesday, Mel Watt, the newly installed overseer of Fannie Mae and Freddie Mac said the mortgage giants should direct their focus toward making more credit available to homeowners, a U-turn from previous directives to pull back from the mortgage market.

In coming weeks, six agencies, including Mr. Watt’s, are expected to finalize new rules for mortgages that are packaged into securities by private investors. Those rules largely abandon earlier proposals requiring larger down payments on mortgages in certain types of mortgage-backed securities.

My god…it seems like the Obama administration wants a new government subsidized subprime market. Good luck with that!

The regulatory wave that have rolled over the US banking and finance industry in the past five years has not made moral hazard problems smaller, but rather the opposite and the continued massive government involvement in housing finance is seriously adding to these problems.

It is very clear that the US housing finance system over the past couple of decades has become insanely politicized. An example is Mr. Watt – the newly appointed overseer of Fannie and Freddie. Mr. Watt do not have a background in finance or in economics. Rather he is a career politician. Is a career politician really what you want if you want to avoid moral hazard? I think not.

Blame Bill Clinton  

In his great book The Great Recession – Market Failure or Policy Failure? Robert Hetzel spells out how  the present housing finance debacle in the US started back in the 1990s during the Clinton administration – with strong bi-partisan support I should say. (See particular 10 in Bob’s book).

Hence, the Clinton administration set ambitious goals to raise homeownership in the US in a document called “The National Homeownership Strategy: Partners in the American Dream”.

The document starts with a message from president Clinton:

“…This past year, I directed HUD Secretary Henry G. Cisneros to work with leaders in the housing industry, with nonprofit organizations, and with leaders at every level of government to develop a plan to boost homeownership in America to an all-time high by the end of this century. The National Homeownership Strategy: Partners in the American Dream outlines a substantive, detailed plan to reach this goal. This report identifies specific actions that the federal government, its partners in state and local government, the private, nonprofit community, and private industry will take to lower barriers that prevent American families from becoming homeowners. Working together, we can add as many as eight million new families to America’s homeownership rolls by the year 2000.”

Did Clinton “succeed”? You bet he did. Just take a look at this graph of the US home ownership rate (I stole it from Bob’s book):

Homeownership rate US

It is hard to avoid the conclusion that there is a clear connection between the US government’s stated goal of boosting homeownership and the actual sharp increasing in homeownership from around 1995.

Therefore, I also find it likely that the sharp increase in housing demand from the mid-1990s was a result of US government policies to subsidize housing finance rather than a result of overly easy monetary policy. There certainly also were other reasons such as demography, but direct and indirect subsidizes likely were the main culprit.

Forgetting monetary policy and increasing moral hazard

In the light of this I completely share Scott’s reaction to the latest policy actions from the Obama administration. It is particularly horrifying that the Obama administration consistently has undermined the efforts to ease US monetary policy during this crisis – among other things by appointing über hawkish Fed officials – while at the same time now is trying to “boost growth” by further increasing moral hazard problems in the US financial system. And just imagine what would have happened if Larry Summers had been appointed new Fed chairman…

That I believe once again shows how policy makers again and again prefer credit policies and quasi-fiscal policies to monetary policy. The result is that we are not really seeing any lift in nominal demand growth, but moral hazard problems continue to increase. That is the case in the US as well as in Europe. Or as Scott so clearly explains it:

So let’s see, we have to taper QE because otherwise the economy will “overheat.” After all, unemployment has fallen to 6.3% and many of the remaining unemployed are supposedly unemployable.  And yet we need to go back to the subprime mortgage economy to juice the economy.  Is that the view of the Fed? Forget about “getting in all the cracks,” can we stop opening up new cracks as wide as the Grand Canyon?”

Get government out of housing finance and implement a rule based monetary policy

The US government involvement in housing finance has been an utter failure. It has strongly increased Too Big To Fail problems and moral hazard in the US financial system and the latest initiatives are likely to further increase the risk of a new housing crisis.

There in my view is only one solution and that is to get the US government completely out of housing finance and to significantly scale back the US government’s (and the Federal Reserve’s) involvement in the credit markets. There are no economic valid arguments for why the US tax payers should subsidize housing finance.

Obviously one can argue that such badly needed reforms in the near-term could tighten financial and credit conditions, which effectively could cause a tightening of monetary conditions (through a drop in the money-multiplier). However, this is no argument against such reforms. Rather it is yet another argument why the Fed should implement a strictly rule based monetary policy – preferably a NGDP target.

If indeed housing finance reforms where to tighten credit conditions and cause the money-multiplier to drop then this can always be counteracted by an increase in the US money base. This of course would happen quasi-automatically under a strict NGDP target.

In that sense there is also a good argument for the Fed and the US government to coordinate such reforms. The US government should reduce its role in the credit markets to a minimum, while the Fed should commit itself to maintaining nominal stability and if needed postponing tapering or even expand quantitative easing as housing finance reform is implemented.

PS I hope this post clearly illustrate that Market Monetarists like Scott and myself are horrified by government involvement in such things as housing finance and that we are deeply concerned about moral hazard problems. We have in the past five years advocated monetary easing to ensure nominal stability, but we have NEVER advocated credit policies of any kind. As a higher level of nominal stability is returning particularly in the US we are likely to increasingly focus on moral hazard problem and yes in 1-2 years time we might start to sound quite hawkish in terms of the Fed’s monetary policy stance, but our views will not have changed. We continue to advocate that governments should get out of the credit markets and housing finance and that central banks should follow clear and transparent monetary policy rules to ensure nominal stability.

Let me say it again – The Kuroda recovery will be about domestic demand and not about exports

This morning we got strong GDP numbers from Japan for Q1. The numbers show that it is primarily domestic demand – private consumption and investment – rather than exports, which drive growth.

This is from Bloomberg:

Japan’s economy grew at the fastest pace since 2011 in the first quarter as companies stepped up investment and consumers splurged before the first sales-tax rise in 17 years last month.

Gross domestic product grew an annualized 5.9 percent from the previous quarter, the Cabinet Office said today in Tokyo, more than a 4.2 percent median forecast in a Bloomberg News survey of 32 economists. Consumer spending rose at the fastest pace since the quarter before the 1997 tax increase, while capital spending jumped the most since 2011.

…Consumer spending rose 2.1 percent from the previous quarter, the highest since a 2.2 percent increase in the first three months of 1997.

So it is domestic demand, while net exports are actually a drag on the economy (also from Bloomberg):

Exports rose 6 percent from the previous quarter and imports climbed 6.3 percent.

The yen’s slide since Abe came to power in December 2012 has inflated the value of imported energy as the nation’s nuclear reactors remain shuttered after the Fukushima disaster in March 2011.

The numbers fits very well with the story I told about the excepted “Kuroda recovery” (it is not Abenomics but monetary policy…) a year ago.

This is what I wrote in my blog post “The Kuroda recovery will be about domestic demand and not about exports” nearly exactly a year ago (May 10 2013):

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

…I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we seeing the yen weaken, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

the focus on the“competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

While I am happy to acknowledge that today’s numbers likely are influenced by a number of special factors – such as increased private consumption ahead of planned sales tax hikes and likely also some distortions of the investment numbers I think it is clear that I overall have been right that what we have seen in the Japanese economy over the past year is indeed a moderate recovery led by domestic demand .

The biggest worry: Inflation targeting and a negative supply shock

That said, I am also worried about the momentum of the recovery and I am particularly concerned about the unfortunate combination of the Bank of Japan’s focus on inflation targeting – rather than nominal GDP targeting – than a negative supply shock.

This is particularly the situation where we are both going to see a sales tax hike – which will increase headline inflation – and we are seeing a significant negative supply shock due to higher energy prices. Furthermore note that the Abe administration’s misguided push to increase wage growth – to a pace faster than productivity growth – effectively also is a negative supply shock to the extent the policy is “working”.

While the BoJ has said it will ignore such effects on headline inflation it is likely to nonetheless at least confuse the picture of the Japanese economy and might make some investors speculate that the BoJ might cut short monetary easing.

This might explain three factors that have been worrying me. First, of all while broad money supply in Japan clearly has accelerated we have not see a pick-up in money-velocity. Second, the Japanese stock market has generally been underperforming this year. Third, we are not really seeing the hoped pick-up in medium-term inflation expectations.

All this indicate that the BoJ are facing some credibility problems – consumers and investors seem to fear that the BoJ might end monetary easing prematurely.

To me there is only one way to fundamentally solve these credibility problems – the BoJ should introduce a NGDP level target of lets say 3-4%. That would significantly reduce the fear among investors and consumers that the BoJ might scale back monetary easing in response to tax hikes and negative supply shocks, while at the same time maintain price stability over the longer run (around 2% inflation over the medium-term assuming that potential real GDP growth is 1-2%).

PS Q1 2014 nominal GDP grew 3.1% y/y against the prior reading of 2.2% y/y.

PPS See also my previous post where I among other things discuss the problems of inflation targeting and supply shocks.

The monetary transmission mechanism – causality and monetary policy rules

Most economists pay little or no attention to nominal GDP when they think (and talk) about the business cycle, but if they had to explain how nominal GDP is determined they would likely mostly talk about NGDP as a quasi-residual. First real GDP is determined – by both supply and demand side factors – and then inflation is simply added to get to NGDP.

Market Monetarists on the other hand would think of nominal GDP determining real GDP. In fact if you read Scott Sumner’s excellent blog The Money Illusion – the father of all Market Monetarist blogs – you are often left with the impression that the causality always runs from NGDP to RGDP. I don’t think Scott thinks so, but that is nonetheless the impression you might get from reading his blog. Old-school monetarists like Milton Friedman were basically saying the same thing – or rather that the causality was running from the money supply to nominal spending to prices and real GDP.

In my view the truth is that there is no “natural” causality from RGDP to NGDP or the other way around. I will instead here argue that the macroeconomic causality is fully dependent about the central bank’s monetary policy rules and the credibility of and expectations to this rule.

In essenssens this also means that there is no given or fixed causality from money to prices and this also explains the apparent instability between the lags and leads of monetary policy.

From RGDP to NGDP – the US economy in 2008-9?

Some might argue that the question of causality and whilst what model of the economy, which is the right one is a simple empirical question. So lets look at an example – and let me then explain why it might not be all that simple.

The graph below shows real GDP and nominal GDP growth in the US during the sharp economic downturn in 2008-9. The graph is not entirely clearly, but it certainly looks like real GDP growth is leading nominal GDP growth.

RGDP NGDP USA 2003 2012

Looking at the graph is looks as if RGDP growth starts to slow already in 2004 and further takes a downturn in 2006 before totally collapsing in 2008-9. The picture for NGDP growth is not much different, but if anything NGDP growth is lagging RGDP growth slightly.

So looking at just at this graph it is hard to make that (market) monetarist argument that this crisis indeed was caused by a nominal shock. If anything it looks like a real shock caused first RGDP growth to drop and NGDP just followed suit. This is my view is not the correct story even though it looks like it. I will explain that now.

A real shock + inflation targeting => drop in NGDP growth expectations

So what was going on in 2006-9. I think the story really starts with a negative supply shock – a sharp rise in global commodity prices. Hence, from early 2007 to mid-2008 oil prices were more than doubled. That caused headline US inflation to rise strongly – with headline inflation (CPI) rising to 5.5% during the summer of 2008.

The logic of inflation targeting – the Federal Reserve at that time (and still is) was at least an quasi-inflation targeting central bank – is that the central bank should move to tighten monetary condition when inflation increases.

Obviously one could – and should – argue that clever inflation targeting should only target demand side inflation rather than headline inflation and that monetary policy should ignore supply shocks. To a large extent this is also what the Fed was doing during 2007-8. However, take a look at this from the Minutes from the June 24-25 2008 FOMC meeting:

Some participants noted that certain measures of the real federal funds rate, especially those using actual or forecasted headline inflation, were now negative, and very low by historical standards. In the view of these participants, the current stance of monetary policy was providing considerable support to aggregate demand and, if the negative real federal funds rate was maintained, it could well lead to higher trend inflation… 

…Conditions in some financial markets had improved… the near-term outlook for inflation had deteriorated, and the risks that underlying inflation pressures could prove to be greater than anticipated appeared to have risen. Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term. Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations.With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting. 

Hence, not only did some FOMC members (the majority?) believe monetary policy was easy, but they even wanted to move to tighten monetary policy in response to a negative supply shock. Hence, even though the official line from the Fed was that the increase in inflation was due to higher oil prices and should be ignored it was also clear that that there was no consensus on the FOMC about this.

The Fed was of course not the only central bank in the world at that time to blur it’s signals about the monetary policy response to the increase in oil prices.

Notably both the Swedish Riksbank and the ECB hiked their key policy interest rates during the summer of 2008 – clearly reacting to a negative supply shock.

Most puzzling is likely the unbelievable rate hike from the Riksbank in September 2008 amidst a very sharp drop in Swedish economic activity and very serious global financial distress. This is what the Riksbank said at the time:

…the Executive Board of the Riksbank has decided to raise the repo rate to 4.75 per cent. The assessment is that the repo rate will remain at this level for the rest of the year… It is necessary to raise the repo rate now to prevent the increases in energy and food prices from spreading to other areas.

The world is falling apart, but we will just add to the fire by hiking interest rates. It is incredible how anybody could have come to the conclusion that monetary tightening was what the Swedish economy needed at that time. Fans of Lars E. O. Svensson should note that he has Riksbank deputy governor at the time actually voted for that insane rate hike.

Hence, it is very clear that both the Fed, the ECB and the Riksbank and a number of other central banks during the summer of 2008 actually became more hawkish and signaled possible rates (or actually did hike rates) in reaction to a negative supply shock.

So while one can rightly argue that flexible inflation targeting in principle would mean that central banks should ignore supply shocks it is also very clear that this is not what actually what happened during the summer and the late-summer of 2008.

So what we in fact have is that a negative shock is causing a negative demand shock. This makes it look like a drop in real GDP is causing a drop in nominal GDP. This is of course also what is happening, but it only happens because of the monetary policy regime. It is the monetary policy rule – where central banks implicitly or explicitly – tighten monetary policy in response to negative supply shocks that “creates” the RGDP-to-NGDP causality. A similar thing would have happened in a fixed exchange rate regime (Denmark is a very good illustration of that).

NGDP targeting: Decoupling NGDP from RGDP shocks 

I hope to have illustrated that what is causing the real shock to cause a nominal shock is really monetary policy (regime) failure rather than some naturally given economic mechanism.

The case of Israel illustrates this quite well I think. Take a look at the graph below.

NGDP RGDP Israel

What is notable is that while Israeli real GDP growth initially slows very much in line with what happened in the euro zone and the US the decline in nominal GDP growth is much less steep than what was the case in the US or the euro zone.

Hence, the Israeli economy was clearly hit by a negative supply shock (sharply higher oil prices and to a lesser extent also higher costs of capital due to global financial distress). This caused a fairly sharp deceleration real GDP growth, but as I have earlier shown the Bank of Israel under the leadership of then governor Stanley Fischer conducted monetary policy as if it was targeting nominal GDP rather than targeting inflation.

Obviously the BoI couldn’t do anything about the negative effect on RGDP growth due to the negative supply shock, but a secondary deflationary process was avoid as NGDP growth was kept fairly stable and as a result real GDP growth swiftly picked up in 2009 as the supply shock eased off going into 2009.

In regard to my overall point regarding the causality and correlation between RGDP and NGDP growth it is important here to note that NGDP targeting will not reverse the RGDP-NGDP causality, but rather decouple RGDP and NGDP growth from each other.

Hence, under “perfect” NGDP targeting there will be no correlation between RGDP growth and NGDP growth. It will be as if we are in the long-run classical textbook case where the Phillips curve is vertical. Monetary policy will hence be “neutral” by design rather than because wages and prices are fully flexible (they are not). This is also why we under a NGDP targeting regime effectively will be in a Real-Business-Cycle world – all fluctuations in real GDP growth (and inflation) will be caused by supply shocks.

This also leads us to the paradox – while Market Monetarists argue that monetary policy is highly potent under our prefered monetary policy rule (NGDP targeting) it would look like money is neutral also in the short-run.

The Friedmanite case of money (NGDP) causing RGDP

So while we under inflation targeting basically should expect causality to run from RGDP growth to NGDP growth we under NGDP targeting simply should expect that that would be no correlation between the two – supply shocks would causes fluctuations in RGDP growth, but NGDP growth would be kept stable by the NGDP targeting regime. However, is there also a case where causality runs from NGDP to RGDP?

Yes there sure is – this is what I will call the Friedmanite case. Hence, during particularly the 1970s there was a huge debate between monetarists and keynesians about whether “money” was causing “prices” or the other way around. This is basically the same question I have been asking – is NGDP causing RGDP or the other way around.

Milton Friedman and other monetarist at the time were arguing that swings in the money supply was causing swings in nominal spending and then swings in real GDP and inflation. In fact Friedman was very clear – higher money supply growth would first cause real GDP growth to pick and later inflation would pick-up.

Market monetarists maintain Friedman’s basic position that monetary easing will cause an increase in real GDP growth in the short run. (M, V and NGDP => RGDP, P). However, we would even to a larger extent than Friedman stress that this relationship is not stable – not only is there “variable lags”, but expectations and polucy rules might even turn lags into leads. Or as Scott Sumner likes to stress “monetary policy works with long and variable LEADS”.

It is undoubtedly correct that if we are in a situation where there is no clearly established monetary policy rule and the economic agent really are highly uncertain about what central bankers will do next (maybe surprisingly to some this has been the “norm” for central bankers as long as we have had central banks) then a monetary shock (lower money supply growth or a drop in money-velocity) will cause a contraction in nominal spending (NGDP), which will cause a drop in real GDP growth (assuming sticky prices).

This causality was what monetarists in the 1960s, 1970s and 1980s were trying to prove empirically. In my view the monetarist won the empirical debate with the keynesians of the time, but it was certainly not a convincing victory and there was lot of empirical examples of what was called “revered causality” – prices and real GDP causing money (and NGDP).

What Milton Friedman and other monetarists of the time was missing was the elephant in the room – the monetary policy regime. As I hopefully has illustrated in this blog post the causality between NGDP (money) and RGDP (and prices) is completely dependent on the monetary policy regime, which explain that the monetarists only had (at best) a narrow victory over the (old) keynesians.

I think there are two reasons why monetarists in for example the 1970s were missing this point. First of all monetary policy for example in the US was highly discretionary and the Fed’s actions would often be hard to predict. So while monetarists where strong proponents of rules they simply had not thought (enough) about how such rules (also when highly imperfect) could change the monetary transmission mechanism and money-prices causality. Second, monetarists like Milton Friedman, Karl Brunner or David Laidler mostly were using models with adaptive expectations as rational expectations only really started to be fully incorporated in macroeconomic models in the 1980s and 1990s. This led them to completely miss the importance of for example central bank communication and pre-announcements. Something we today know is extremely important.

That said, the monetarists of the times were not completely ignorant to these issues. This is my big hero David Laidler in his book Monetarist Perspectives” (page 150):

“If the structure of the economy through which policy effects are transmitted does vary with the goals of policy, and the means adopted to achieve them, then the notion of of a unique ‘transmission mechanism’ for monetary policy is chimera and it is small wonder that we have had so little success in tracking it down.”

Macroeconomists to this day unfortunately still forget or ignore the wisdom of David Laidler.

HT DL and RH.

It was monetary policy failure – also in Romania

My friend Florin Citu has a new blog post on monetary policy failure in Romania.

Here is Florin’s assessment:

…monetary policy was pro-cyclical- high money supply growth (M1) until December 2007 and an abrupt decrease to negative money supply growth after that. The peak of money supply growth is in December 2007 while the peak of NGDP growth is in September 2007. In the 9 months money supply growth decreased from 64% per year to 38% per year. Most importantly, the minimum for both money supply growth and NGDP growth is in December 2009 (one year after the exogenous negative shock of October 2008). Monetary policy continued to remain tight for a long period after October 2008 while most of the global central banks were relaxing monetary policy or at least keeping money supply growth constant.

This graph says it all.

m1ngdppol

So why did the Romanian central bank first allow the money supply to grow so strongly and then allowed the sharp contraction in money supply growth? This is Florin:

…monetary policy targeted mainly the exchange rate and only secondary inflation. It is true that the exchange rate has been less volatile but it did follow the pattern we observe in countries with currency boards: relative stability followed by a big devaluation. However, relative exchange rate stability came with a big real cost for the economy: volatility in the interest rates and inflation. Interest rate volatility, especially in the interbank market, represented funding costs uncertainty for banks which was transferred to clients via higher premium for the RON lending market. An unintended consequence of this policy was that it made foreign exchange loans more attractive. Thus interventions in the FX market acted as a subsidy for both supply and demand of FX denominated loans. Bottom line, FX interventions were not free and worst of all were also pro -cyclical with real costs for the economy.

Again Florin is completely right. The Romanian central bank was clearly preoccupied with the development in the currency markets. As the crisis hit there was a global spike in dollar demand and as a result investors were selling basically all other currencies. This was also the case for the Romanian leu (RON)).

But what caused the central bank to have this fear-of-floating? I think the answer is that the Romanian central bank did not have the proper monetary policy target and failed to focus on one target. A large amount of Romanian households and corporations had foreign currency loans in 2008 (and still do).

The Romanian central bank clearly feared that this foreign currency exposure could trigger a financial crisis if the leu was allowed to drop sharply. As a consequence the central bank moved to tighten monetary policy dramatically to “defend” (which is nonsense in free floating currency regime) against what the central bank believe was a “speculative attack” (this is also nonsense – floating exchange rates do not come under “attack”).

The monetary tightening caused the sharp de-acceleration in the money supply, which in turned caused a sharp contraction in nominal GDP. So yes, the central bank was trying to protect households and companies with foreign currency loans, but also at the same time sent the Romanian economy into a deep recession. A recession that Romania has not fully emerged from.

I still fail to why the Romanian central bank saw it as it’s task to effectively protect those who had speculated in foreign currency loans rather than ensuring nominal stability. By effectively trying to bail-out households and companies with FX loans the Romanian central bank has increased moral hazard problems, but at the same time kept the Romanian economy on a “low growth path”.

The Romanian monetary policy failure over the past five years is yet another example of what happens when central bankers try to play firefighters rather than sticking to transparent rules to ensure nominal stability. If you asked me for advise then the Romanian central bank should adopt a NGDP target and the let the leu float freely without an interference from the central bank.

PS I should say that I think that the Romanian economy is now in a moderate recovery (See more here). This I believe is mostly a result of imported monetary easing on the back of the easing of the euro crisis. However, the Romanian central bank does not have to rely on the actions of the ECB and the Fed to bring out of the crisis. The Romanian central bank is fully able to control nominal spending in the Romanian economy.

 

 

Gary Becker has died. Long live economic imperialism!

As geopolitical tensions in Ukraine have been rising I have found myself thinking about the impact of such events on markets and economies. One thing is to understand what is actually going on and another thing is to understand the economics of such events. How are geopolitical tension or terror impacting investment and consumption decision?

Most people would tend to give ad hoc explanations for the economic and financial impact of such events. However, that would not be the way I would look at it. I would always start out by trying to understand such events and the impact of such events from a rational choice perspective. The tools economists use to understand the pricing of beer or the demand for football tickets can also – and should – be used to understand for example suicide bombings or how markets react to geopolitical tensions.

This was the key message from Nobel laureate Gary Becker who passed away on Sunday at an age of 83.

Becker was awarded the Nobel Prize in economics in 1992 “for having extended the domain of microeconomic analysis to a wide range of human behaviour and interaction, including nonmarket behaviour”.

Airport security and the Economics of discrimination

Gary Becker is one of the economists who has had the biggest influence on my thinking about the world in general – also the “nonmarket world” – so his ideas often come up when I encounter different decision making problems.

Recently I was going through security control in Copenhagen airport. In Copenhagen airport there is a special security control called something like the “Express” track. It is basically a quasi-fast track. I fundamentally think it is used to get people who are late for the their flight fast through security and for example for people in wheelchair. However, I have noticed that I often will be called over to this Express track. Last time that happened a couple of weeks ago I came to think about the concept of “statistical discrimination”.

The idea with statistical discrimination is that it can be rational for example for employers to discriminate against certain ethic groups if there is a cost of gathering information of about individuals’ skills. While Gary Becker did not come up with the theory of statistical discrimination he nonetheless was the economist to pioneer the economics of discrimination. His work on discrimination was published in his great book The Economics of Discrimination from 1971.

Becker books

So why am I so often called to the “Express” security control in Copenhagen airport? The answer is statistical discrimination. When I travel I am mostly wearing a suit and look like a seasoned business traveler. The security staff will based on my looks fast conclude that I am a seasoned traveler and know the security routine well and I therefore would not slowdown the process if they got me through there. This obviously was completely rational because I am in fact well accustomed with the security process.

As I was going through the express security control I was thinking about Gary Becker and what he taught us about using standard economic thinking (rational choice theory) to understand non-market phenomena.

Fear and the Response to Terrorism   

I consume a fair amount of working papers every month. As it happens the last working paper I read (or actually re-read) was a paper by Gary Becker (and Yona Rubinstein). The paper – “Fear and the Response to Terrorism: An Economic Analysis” (2011) – “offers a rational approach to the economics and psychology of fear”.

The reason I re-read the paper was that wanted to better understand how the increased geopolitical tensions in Ukraine might impact particularly the Central and Eastern European markets and economies.

Try to think about the geopolitical tensions while reading this part from the abstract from the paper:

“We explicitly consider both the impact of danger on emotions and the distortive effect of fear on subjective beliefs and individual choices. Yet, we also acknowledge individuals’ capacity to manage their emotions. Though costly, people can learn to control their fear and economic incentives affect the degree to which they do so. Since it does not pay back the same returns to everyone, people will differ in their reaction to impending danger … Education and the exposure to media coverage also matters. We find a large impact of suicide attacks during regular media coverage days, and almost no impact of suicide attacks when they are followed by either a holiday or a weekend, especially among the less educated families and among occasional users.”

This might help us understand why the increase in geopolitical tensions in Ukraine and Russia has had so relatively limited impact on global financial markets. Obviously there has been a marked impact on the Russian and Ukrainian markets, but while we initially saw a “fear factor” in the global stock markets this “shock” fast ebbed.

In reality there is a similarly to Becker’s original theory of discrimination, where economic agents could have a “taste” for discrimination. Hence, an employer might have a dislike for jews or blacks, but this “fear” is not for free. If the employer refuses to hire a certain individual because of his or her race or religion despite that individual is as productive as a more open-minded competitor might hire other candidates for the job then that individual. Therefore racist employers will have to pay for their racism by having to accept a lower profit.

Similar it is costly to maintain an irrational fear of geopolitical risks. This I think is pretty important in terms of understanding the impact of the Ukrainian crisis on the global markets.

Long live economic imperialism!

This is just a few examples of how Beckerian thinking is influencing my own thinking at the moment. Gary Becker made a huge impact of me when I really got into studying his research in the second half of the 1990s when I was doing research on the economics of immigration at the Danish Ministry of Economic Affairs and at the same time was teaching a course in the Economics of Immigration at the University of Copenhagen.

I will gladly admit that I am a strong proponent of economic imperialism. I strongly believe – and learned that from studying Gary Becker – that economic method (rational choice theory) can be used to understand most societal issues whether it is stock market pricing, suicide bombings, why politicians are asshats or sports. In fact the latest book to arrive in my mail from Amazon I got to today is a book – “The Numbers Game” – on how to apply economic methods to understanding football (for my American readers – that is what we call soccer in Europe).

I am sure Gary Becker would have agreed that if you want to understand for example the impact on team success by firing a coach you need to apply rational choice theory. It is not about “psychology” – it is all about rational choices.

Thank you Gary Becker for making me understand this.

Numbers game

Update – See also these links on Gary Becker:

Greg Mankiw: Very Sad News

Peter Lewin: Gary Becker: A Personal Appreciation

David Henderson: Gary Becker, RIP

Bloomberg: Gary Becker, Who Applied Economics to Social Study, Dies at 83

Reuters: Nobel-Winning Economist Gary Becker Dies at 83

Chicago Tribune: Nobel-prize winning economist Gary Becker dead at 83

Fox News: Gary Becker, University of Chicago Economics Nobel Laurete, Dies at Age 83

Peter Boettke: Gary Becker (1930-2014) — An Economist for the Ages

Mario Rizzo: Gary Becker (1930 – 2014): Through My Austrian Window

Russ Robert/Café Hayek: Gary Becker, RIP

 

 

 

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