Great, Greater, Greatest – Three Finnish Depressions

Brad DeLong has suggested that we rename the Great Recession the GreatER Depression in Europe as the crisis in terms of real GDP lose now is bigger in Europe than it was it during the Great Depression.

Surely it is a very simplified measure just to look at the development in the level of real GDP and surely the present socio-economic situation in Europe cannot be compared directly to the economic hardship during the 1930s. That said, I do believe that there are important lessons to be learned by comparing the two periods.

In my post from Friday – Italy’s Greater Depression – Eerie memories of the 1930s – I inspired by the recent political unrest in Italy compared the development in real GDP in Italy during the recent crisis with the development in the 1920s and 1930s.

The graph in that blog post showed two things. First, Italy’s real GDP lose in the recent crisis has been bigger than during 1930s and second that monetary easing (a 41% devaluation) brought Italy out of the crisis in 1936.

I have been asked if I could do a similar graph on Finland. I have done so – but I have also added the a third Finnish “Depression” and that is the crisis in the early 1990s related to the collapse of the Soviet Union and the Nordic banking crisis. The graph below shows the three periods.

Three Finnish Depressions

(Sources: Angus Maddison’s “Dynamic Forces in Capitalist Development” and IMF, 2014 is IMF forecast)

The difference between monetary tightening and monetary easing

The most interesting story in the graph undoubtedly is the difference in the monetary response during the 1930s and during the present crisis.

In October 1931 the Finnish government decided to follow the example of the other Nordic countries and the UK and give up (or officially suspend) the gold standard.

The economic impact was significant and is very clearly illustrate in the graph (look at the blue line from year 2-3).

We have nearly imitate take off. I am not claiming the devaluation was the only driver of this economic recovery, but it surely looks like monetary easing played a very significant part in the Finnish economic recovery from 1931-32.

Contrary to this during the recent crisis we obviously saw a monetary policy response in 2009 from the ECB – remember Finland is now a euro zone country – which helped start a moderate recovery. However, that recovery really never took off and was ended abruptly in 2011 (year 3 in the graph) when the ECB decided to hike interest rate twice.

So here is the paradox – in 1931 two years into the crisis and with a real GDP lose of around 5% compared to 1929 the Finnish government decided to implement significant monetary easing by devaluing the Markka.

In 2011 three  years into the present crisis and a similar output lose as in 1931 the ECB decided to hike interest rates! Hence, the policy response was exactly the opposite of what the Nordic countries (and Britain) did in 1931.

The difference between monetary easing and monetary tightening is very clear in the graph. After 1931 the Finnish economy recovered nicely, while the Finnish economy has fallen deeper into crisis after the ECB’s rate hikes in 2011 (lately “helped” by the Ukrainian-Russian crisis).

Just to make it clear – I am not claiming that the only thing import here is monetary policy (even though I think it nearly is) and surely structural factors (for example the “disappearance” of Nokia in recent years and serious labour market problems) and maybe also fiscal policy (for example higher defense spending in the late-1930s) played role, but I think it is hard to get around the fact that the devaluation of 1931 did a lot of good for the Finnish economy, while the ECB 2011’s rate hikes have hit the Finnish economy harder than is normally acknowledged (particularly in Finland).

Finland: The present crisis is The Greatest Depression

Concluding, in terms of real GDP lose the present crisis is a GreatER Depression than the Great Depression of the 1930s. However, it is not just greater – in fact it is the GreatEST Depression and the output lose now is bigger than during the otherwise very long and deep crisis of the 1990s.

The policy conclusions should be clear…

PS this is what the New York Times wrote on October 13 1931) about the Finnish decision to suspend the gold standard:

“The decision of taken under dramatic circumstances…foreign rates of exchange immediately soared about 25 per cent”

And the impact on the Finnish economy was correctly “forecasted” in the article:

“In commercial circles it is expected that the suspension (of the gold standard) will greatly stimulate industries and exports.”

HT Vladimir

Related post:
Currency union and asymmetrical supply shocks – the case of Finland


Macroprudential follies and procyclical central bankers

A couple of days ago I came across an article from Bloomberg, which I think is very telling about everything which is wrong about the recent hype about macroprudential policies.

This is from Bloomberg:

When Katja Taipalus came home from school every day in the Finnish town of Jalasjaervi, she knew her working parents wouldn’t be there. Instead, her retired grandfather, who also lived in the large wooden house, played cards and other games with her. They even repaired a car.

Those discussions taught her to stay focused when she became an economist and her research hit a dead end, she says. The end result: an indicator that helps detect asset-price bubbles in equity and housing markets — as much as a year in advance.

“Asset prices have been one of the main components as financial crises have built up,” she said in the Bank of Finland’s historic teller hall in Helsinki, its walls decorated with giant tapestries. “If we think of the tools needed to allow policy makers time to react,” one of the main ones is “getting a signal as early as possible about an asset-price bubble in the making.”

Drawing up the indicator earned Taipalus her Ph.D. last year at the University of Turku, after four-and-a-half years of study alongside full-time work at the Finnish central bank. She heads the macroprudential-analysis division of the financial-stability and statistics department, running a team of seven economists and experts who work on analysis and applied research.

There you got it. The head of macroprudential analysis in Bank of Finland apparently is able to “forecast” every major turn in the US stock market the last 140 year! (See her paper on the issue here)

I don’t know anything about Ms. Taipalus’ private wealth, but if this is true she have to be a very wealthy person indeed. If you are able to build such a model you should be able to make enormous profits. But the truth is of course that you cannot really build a model that can do this. Economists, speculators and charlatans have tried to do this as long as we have had financial markets and the truth is that nobody consistently is able to beat the market.

Yes, we might find indicators and models that might historically have worked, but the point is that once these model or indicators becomes known they will breakdown as everybody would start to use them. This is the case of stock markets and it is the the case in the  baseball market (See here why Oakland A’s stopped winning).

You might think that this is Econ 101, but nowadays central bankers increasingly think they can beat the markets. This is at the core of macroprudential thinking. Central bankers will design models and indicators to spot bubbles and imbalances in the economy and use these models to counteract “excesses” in the financial sector by increasing for example capital and liquidity ratios. I personally find the theoretical and empirical foundation for this extremely flawed.

The proponents of macroprudential policies fail to understand the basic truth of Goodhart’s Law – When a measure becomes a target, it ceases to be a good measure. It is that simple.

Procyclical central bankers

Another very serious flaw in macroprudential thinking is that not only is it assumed that central bankers can beat the market, it is also assumed that central bankers are benevolent dictators who will always do the right thing when they spot a bubble. However, we all know that central bankers are far from all-knowing benevolent dictators – if they were then there would never had been any crisis at all.

I certainly did not hear many central bankers who both warned about the risk of crisis prior to 2008 and at the same time initiated policies to avoid the crisis unfolding. In fact I only remember debating numerous central bankers prior to 2008 who all consistently said that everything was just fine.

A way to illustrate central bankers abilities to beat the market and use that information to their own advantage is the management of foreign exchange reserves. If central bankers indeed are more clever than market participants then one should expect FX reserves to to yield an higher and less risky return than for example privately managed pension funds.

Unfortunately most central banks are not exactly transparent about their ability to manage FX reserves so it is hard to find any good comparison between central bankers and private sector asset mangers abilities to undertake asset allocation. But as far as I can see there is absolutely no evidence that central bank asset managers consistently beat private sector asset managers.

I have found a quite interesting IMF study – Procyclicality in Central Bank Reserve Management: Evidence from the Crisis – by Jukka Pihlman and Han van der Hoorn from 2010, which should give serious doubt about central bankers abilities in terms of spotting bubbles. Just take a look at the abstract:

A decade-long diversification of official reserves into riskier investments came to an abrupt end at the beginning of the global financial crisis, when many central bank reserve managers started to withdraw their deposits from the banking sector in an apparent flight to quality and safety. We estimate that reserve managers pulled around US$500 billion of deposits and other investments from the banking sector. Although clearly not the main cause, this procyclical investment behavior is likely to have contributed to the funding problems of the banking sector, which required offsetting measures by other central banks such as the Federal Reserve and Eurosystem central banks. The behavior highlights a potential conflict between the reserve management and financial stability mandates of central banks. This paper analyzes reserve managers’ actions during the crisis and draws some lessons for strategic asset allocation of reserves going forward.

Concluding, central banks during booms tend to take on more risk – they overweight risky assets – while they during busts tend to reduce risk – underweight risky assets. Hence, central banks consistently act in a procyclical fashion.

This is of course is not only bad in terms of ensuring the highest and most stable return at the lowest possible risk, but it also adds to the swings in the economy as the central bank will add liquidity to the financial system during booms and redraw liquidity during crashes.

As the authors of the IMF study states:

When the crisis hit (in 2008), many central banks withdrew these investments, in some cases rather abruptly, in ways very similar to commercial asset managers. Traditionally very conservative investors, with a low appetite for risk, the crisis response of reserve managers was perhaps unsurprising—and from an individual reserve manager’s perspective even rational—yet the withdrawal of central bank investments also put further pressure on the banking sector when other sources of funding dried up simultaneously and spreads exploded. In some countries, the withdrawal was unavoidable, as reserves were urgently needed for intervention or to finance domestic support measures during the crisis. In most countries, though, reserves were not used, or the amount used was much smaller than the withdrawal of investments from the banking sector. In each case, and certainly in aggregate, reserve managers acted very procyclically, and may well have been in conflict with the more prominent financial stability objectives of the central bank. Through such behavior, reserve managers may have contributed, albeit unintentionally, to the funding problems in some banks, and have forced an even stronger policy response by the authorities in countries issuing a reserve currency.

The authors also quotes a yearly survey of Reserve Management Trends (RMT) from Central Banking Publications. This is from RMT in 2007 – one year ahead of the crisis:

“The trend for central banks to invest in riskier assets in the search for yield has continued…Many respondents gave what they saw as the reason for the continuation of this trend. In particular, several emphasised the low-yield environment.”

So it might be that the head of macroprudential analysis at the Bank of Finland can forecast all stock market busts one-year in advantage, but apparently her colleagues in most central banks of the world did not have access to her models. Too bad…

So I remain skeptical about the usefulness of macroprudential policies – in fact I believe that an over-reliance on such policies could lead to an increase in the volatility and fragility of the global financial system rather than the opposite.

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