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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.

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When central banking becomes central planning

The great thing about the blogosphere is that everything is happening in “real-time”. In economic journals the exchange of ideas and arguments can go on forever without getting to any real conclusion and some debates is never undertaken in the economic journals because of the format of journals.

Such a debate is the discussion about whether central banking is central planning, which has been going on between the one hand Kurt Schuler and on the other hand David Glasner and Bill Woolsey. Frankly speaking, I shouldn’t really get involved in this debate as the three gentlemen all are extreme knowledgeable about exactly this topic and they have all written extensively about Free Banking – something that I frankly has not written much about.

In my day-job central banks are just something we accept as a fact that is not up for debate. Anyway, I want to let me readers know about this interesting debate and maybe add a bit of my humble opinion as we go along. There is, however, no reason to “reprint” every single argument in the debate so here are the key links:

From Glasner:

“Gold and Ideology, continued”

“Central Banking is not Central Planning”

“Hayek on the meaning of planning”

“Central Banking and Central Planning, again”

From Schuler:

“Central Banking is a form of Central Planning”

“Once more: central banking is a form of central planning”

From Woolsey:

“Central Banking is Not Central Planning”

Initially my thinking was, yes, of course central banking is central planning, but Bill Woolsey arguments won the day (Sorry David, the Hayek quotes didn’t convince me…).

Here is Bill Woolsey:

“Comprehensive central planning of the economy is the central direction of the production and consumption of all goods services. How many cars do we want this year? How much steel is needed to produce those cars? How much iron ore is needed to produce the steel?…Trying to do this for every good and service all the time for millions of people producing and consuming is really, really hard. Perhaps impossible is not too strong of a word, though that really means impossible to do very well at all, much less do better than a competitive market system…Central banking is very different. It does involve having a monopoly over a very important good–base money. Early on, governments sold that monopoly to private firms, but later either explicitly nationalized the central banks, or regulated and “taxed” them to a point where any private elements are just window dressing…Schuler’s error is to identify this monopoly on the provision of an important good with comprehensive central planning. Yes, a monopolist must determine how much of its product to produce and what price to charge. The central bank must determine what quantity of base money to produce and what interest rate to pay (or charge) on reserve balances. But that is nothing like determining how much of each and every good is to be produced while making sure that the resources needed to produce them are properly delivered to the correct places at the correct times.”

Bill continues (here its gets really convincing…):

“Suppose electric power was produced as a government monopoly. That is certainly realistic. The inefficiency of multiple sets of transmission lines provides a plausible rationale. The government power monopoly would need to determine some pricing scheme and how much power to generate. And, of course, these decisions would have implications for the overall level of economic activity. Not enough capacity, and blackouts disrupt economic activity. Too much capacity, and the higher rates needed to pay for it deter economic activity…It is hard to conceive of an electric utility centrally directing the economy, but it isn’t impossible. Ration electricity to all firms based upon a comprehensive plan for what they should be doing. Any firm that produces the wrong amount and sends it to the wrong place is cut off.”

Central banking might not be central planning

Hence, there is a crucial difference between central planning and a government monopoly on the production of certain goods (as for example money). One can of course argue that if government produces anything it is socialism and therefore central planning. However, then central planning loses its meaning and will just become synonymous with socialism. Therefore, arguing that central banking is central planning as Schuler does is in my view wrong. It might be a integral part of an socialist economic system that money is monopolized, but that is still not the same thing as to say central banking is central planning.

But increasingly central banking is conducted as central planning

While central banking need not to be central banking it is also clear that during certain periods of history and in certain countries monetary policy has been conducted as if part (or actually being part of) a overall central planning scheme. In fact until the early 1980s most Western European economies and the US had massively regulated financial markets and credit and money were to a large extent allocated with central planning methods by the financial authorities and by the central banks. Furthermore, exchange controls meant that there was not a free flow of capital, which “necessitated” central planning of which companies and institutions should have access to foreign currency. Therefore, central banking during the 1970s for example clearly involved significant amounts of central planning.

However, the liberalization of the financial markets in most Western countries during the 1980s sharply reduced the elements of central planning in central banking around the world.

The Great Recession, however, has lead to a reversal of this trend away from “central bank planning” and central banks are increasingly involved in “micromanagement” and what clear feels and look like central planning.

In the US the Federal Reserve has been highly involved in buying “distressed assets” and hence strongly been influencing the relative prices in financial markets. In Europe the ECB has been actively interfering in the pricing of government bonds by actively buying for example Greek or Italian bonds to “support” the prices of these bonds. This obviously is not central banking, but central planning of financial markets. It is not and should not be the task of central banks to influence the allocation of credit and capital.

With central banks increasingly getting involved in micromanaging financial market prices and trying to decide what is the “right price” (contrary to the market price) the central banks obviously are facing the same challenges as any Soviet time central planning would face.

Mises and Hayek convincing won the Socialist calculation debate back in the 1920s and the collapse of communism once and for all proved the impossibility of a central planned economy. I am, however, afraid that central banks around the world have forgotten that lesson and increasing are acting as if it was not Mises and Hayek who prevailed in the Socialist-calculation debate but rather Lerner and Lange.

Furthermore, the central banks’ focus on micromanaging financial market prices is taking away attention from the actual conduct of monetary policy. This should also be a lesson for Market Monetarists who for example have supported quantitative easing in the US. The fact remains that what have been called QE in the US in fact does not have the purpose of increasing the money supply (to reduce monetary disequilibrium), but rather had the purpose of micromanaging financial market prices. Therefore, Market Monetarists should again and again stress that we support central bank actions to reduce monetary disequilibrium within a rule-based framework, but we object to any suggestion of the use  central planning “tools” in the conduct of monetary policy.

Do you remember Friedman’s “plucking model”?

Clark Johnson’s paper on the Great Recession has reminded me of Milton Friedman’s so-called “Plucking model” as Johnson mentions Friedman original 1966 paper on the Plucking model. I haven’t thought of the Plucking model for some time, but it is indeed an important contribution to economic theory which in my view is somewhat under-appreciated.

At the core of the Plucking model is that the business cycle is asymmetrical. If you studies modern day textbooks on Macroeconomics it will talk about the “output gap” as it is something we can observe in the real world and a lot of econometric modeling is done under the assumption that real GDP move symmetrically around “potential GDP” over time.

The idea in the Plucking model is, however, that the business cycle really can’t be symmetrical as no economy can produce more than at full capacity. Hence, all shocks in the model will have to be negative shocks – or shocks to the potential GDP. Simply expressed negative shocks are demand shocks and positive shocks are supply shocks – and Friedman assumes that the demand shocks dominates.

A numbers of older and relatively new research confirms empirically the the Plucking model, but for some reason it is not getting a lot of attention.

A key implication of the Plucking model is that there is not correlation between the extent and the size of the “boom” prior to a crisis and how fast the recovery is afterwards. The implication of this is that the idea of “The New Normal” where we will have to have lower growth in the coming years because of “overspending” prior to the crisis simply does not find support in economic history.

Here is a recent interesting paper that finds empirical support for the Plucking model – including for the period covering the Great Recession.

Needless to say – Austrian business cycle fanatics do not agree with the conclusions in the Plucking model…

More research on the Plucking model would be interesting and it would be interesting to see how Market Monetarists can learn from the model.

Clark Johnson has written what will become a Market Monetarist Classic

As I have written about in an earlier post I am reading Clash Johnson’s book on the Great Depression “Gold, France and the Great Depression”. So far it has proved to be an interesting and insightful book on what (to me) is familiar story of how especially French and US gold hoarding was a major cause for the Great Depression.

Clark Johnson’s explanation of Great Depression is similar to that of two other great historians of the Great Depression Scott Sumner and Douglas Irwin. Both are of course as you know Market Monetarists.

Given Johnson’s “international monetary disorder view” of the Great Depression I have been wondering whether he also had a Market Monetarist explanation for the Great Recession. I now have the answer to that question and it is affirmative – Clark Johnson is indeed a Market Monetarist, which becomes very clear when reading a new paper from the Milken Institute written by Johnson.

One thing I find especially interesting about Johnson’s paper is that he notes the importance of the US dollar as the global reserve currency and this mean that US monetary policy tightening has what Johnson calls “secondary effects” on the global economy. I have long argued that Market Monetarists should have less US centric and more global perspective on the global crisis. Johnson seems to share that view, which is not really surprising given Johnson’s work on the international monetary perspective on the Great Depression.

Johnson presents six myths about monetary policy and the six realities, which debunk these myths. Here are the six myths.

Myth 1: The Federal Reserve has followed a highly expansionary monetary policy since August, 2008.

Johnson argues that US monetary policy has not been expansionary despite the increase in the money base and the key reason for this is a large share of the money base increase happened in the form of a similar increase in bank reserves. This is a result of the fact that the Federal Reserve is paying positive interest rates on excess reserves. This is of course similar to the explanation by other Market Monetarists such as David Beckworth and Scott Sumner. Furthermore, Johnsons notes that the increase that we have seen in broader measure of the money supply mostly reflects increased demand for dollars rather than expansionary monetary policies.

Johnson notes in line with Market Monetarist reasoning: “Monetary policy works best by guiding expectations of growth and prices, rather than by just reacting to events by adjusting short-term interests”.

Myth 2: Recoveries from recessions triggered by financial crises are necessarily low.

Ben Bernanke’s theory of the Great Depression is a “creditist” theory that explains (or rather does not…) the Great Depression as a consequence of the breakdown of financial intermediation. This is also at the core of the present Fed-thinking and as a result the policy reaction has been directed at banking bailouts and injection of capital into the US banking sector. Johnson strongly disagrees (as do other Market Monetarists) with this creditist interpretation of the Great Recession (and the Great Depression for that matter). Johnson correctly notes that the financial markets failed to react positively to the massive US banking bailout known as TARP, but on the other hand the market turned around decisively when the Federal Reserve announced the first round of quantitative easing (QE) in March 2009. This in my view is a very insightful comment and shows some real Market Monetarist inside: This crisis should not be solved through bailouts but via monetary policy tools.

Myth 3: Monetary policy becomes ineffective when short-term interest rates fall close to zero.

If there is an issue that frustrates Market Monetarists then it is the claim that monetary policy is ineffective when short-term rates are close to zero. This is the so-called liquidity trap. Johnson obviously shares this frustration and rightly claims that monetary policy primarily does not work via interest rate changes and that especially expectations are key to the understanding of the monetary transmission mechanism.

Myth 4: The greater the indebtedness incurred during growth years, the larger the subsequent need for debt reduction and the greater the downturn.

It is a widespread view that the world is now facing a “New Normal” where growth will have to be below previous trend growth due to widespread deleveraging. Johnson quotes David Beckworth on the deleveraging issue as well site Milton Friedman’s empirical research for the fact there is no empirical justification for the “New Normal” view. In fact, the recovery after the crisis dependent on the monetary response to the crisis than on the size of the expansion prior to the crisis.

Myth 5: When money policy breaks down there is a plausible case for a fiscal response.

Recently the Keynesian giants Paul Krugman and Brad DeLong have joined the Market Monetarists in calling for nominal GDP targeting in the US. However, Krugman and DeLong continue to insist on also loosening of US fiscal policy. Market Monetarists, however, remain highly skeptical that a loosening of fiscal policy on its own will have much impact on the outlook for US growth. Clark Johnson shares this view. Johnson’s view on fiscal policy reminds me of Clark Warburton’s position on fiscal policy: fiscal policy only works if it can alter the demand for money. Hence, fiscal policy can work, but basically only through a monetary channel. I hope to do a post on Warburton’s analysis of fiscal policy at a later stage.

Myth 6: The rising prices of food and other commodities are evidence of expansionary policy and inflationary pressure.

It is often claimed that the rise in commodity prices in recent years is due to overly loose US monetary policy. Johnson refute that view and instead correctly notes that commodity price developments are related to growth on Emerging Markets in particular Asia rather than to US monetary policy.

Johnson’s answer: Rate HIKES!

Somewhat surprise after conducting an essentially Market Monetarist analysis of the causes of the Great Recession Clark Johnson comes up with a somewhat surprising policy recommendation – rate hikes! In fact he repeats Robert McKinnon’s suggestion that the four leading central banks of the world (the Federal Reserve, the ECB, the Bank of Japan and the Bank of England) jointly and coordinated increase their key policy rates to 2%.

Frankly, I have a very hard time seeing what an increase interest rates could do to ease monetary conditions in the US or anywhere else and I find it very odd that Clark Johnson is not even discussing changing the institutional set-up regarding monetary policy in the US after an essentially correct analysis of the state US monetary policy. It is especially odd, as Johnson clearly seem to acknowledge the US monetary policy is too tight. That however, does not take anything away from the fact that Clark Johnson has produced a very insightful and interesting paper on the causes for the Great Recession and monetary policy makers and students of monetary theory can learn a lot from reading Clark Johnson’s paper. In fact I think that Johnson’s paper might turnout to become an Market Monetarist classic similar to Robert Hetzel’s “Monetary Policy in the 2008-2009 Recession” and Scott Sumner’s “Real problem is nominal”.

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Update: Marcus Nunes and David Beckworth also comment on Clark Johnson’s paper. Thanks to both Benjamin “Mr. PR” Cole and Marcus Nunes for letting me know about Johnson’s great paper.

“Our Monetary ills Laid to Puritanism”

Douglas Irwin has been so nice to send me an article from the New York Times from November 1 1931. It is a rather interesting article about the Swedish monetary guru Gustav Cassel’s view of monetary policy and especially how he saw puritanism among monetary policy makers as the great ill. I had not read the article when I wrote my comment on Calvinist economics, but I guess my thinking is rather Casselian.

The New York Times article is based on an article from the Swedish conservative Daily Svenska Dagbladet (the newspaper still exists).

Professor Cassel claims that overly tight US monetary policy in the early 1930s is due to two “main ills”: “deflation mania” and “liquidation fever”.

NYT quote Cassel: “The deeper psychological explanation of this whole movement..can without doubt be found in American Puritanism. This force assembled all its significant resources in what was considered a great moral attack on the diabolism of speculation. Each warning against deflation has stranded on fear on the part of Puritanism that a more liberal monetary policy might infuse new vigor in the spirit speculation.”

It isn’t it scary how much this reminds you about how today’s policy makers are scared of bubbles and inflation? I wonder what Gustav Cassel would tell the ECB to do today?

Maybe here would just say: “That the deflation has meant the ruin of one business after another and forced many banks to suspend payments is a matter that little concerns the stern Puritan”…”on the contrary, it is highly approves proper punishment of speculation and thorough cleaning out of questionable business projects. It totals disregards the fact that deflation in itself by degrees adversely affects the finances of any enterprise and forces even sound business to ruin”. 

Wouldn’t it be a blessing if Cassel was around today to advise central bankers? And that they actually would listen…but of course if you are a puritan or what I termed a believer on Calvinist economics then you don’t have to listen because all you want it just doom and pain to punish all the evil speculators.

 

 

 

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