"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Saturday, February 27, 2010

Really great and worthwhile links - countercyclical barter - leaning against the wind - Krugman - Brad DeLong - two LRAS curves

Nick Rowe - Is Barter Countercyclical? - "Barter increases in recessions, like now, and decreases in booms. Can anyone confirm this? Because that fact (if it is a fact) is really important in understanding the nature of business cycles and recessions. Countercyclical barter is exactly what one would predict from a monetary (deficient aggregate demand) theory of recessions. It makes no sense from a real business cycle or recalculation theory of recessions."

Hans Gersbach - "In boom periods, central banks can "lean against the wind" by using a combination of short-term interest rate increases and raising the required aggregate bank-equity ratios. For instance, in a boom with low inflation and rapid growth of the banking sector’s balance sheet, raising the aggregate equity ratio might be the primary vehicle for moderating the boom, putting a lower weight on interest rate hikes. If the boom is accompanied by higher inflation, increasing short-term interest rates can be used together with higher aggregate bank-equity requirements to moderate inflation and to prevent the build-up of excessive leverage in the entire banking sector, thus lowering the risk of a future banking crisis. As a consequence, many of the drawbacks of Basel II (see Hellwig (2008)) can be avoided."

Paul Krugman - "Effective protection: Imagine autos cost $10,000 on foreign market. Suppose that a 20% tariff is placed on auto imports. However, only assembly locates in your country; imported inputs of $8,000. Then, arguably, domestic assembly industry receives 100% protection: at domestic prices it adds $4000 to value added even though at international prices it adds only $2000"

Brad DeLong - "Third, Barro characterizes the stimulus bill as a two-year $600 billion increase in government purchases. But about half of the stimulus money spent to date is on the tax and transfer side, and about a quarter is direct aid to states which enables them not to raise taxes during this recession. It seems to me that Barro should be weighted-averaging his spending multiplier of 0.6 and his tax multiplier of 1.1 to get an ARRA multiplier of 0.9—in which case our social profit is not $160 billion but rather $340 billion, and we should certainly do this again, and again, and again. (Until, that is, there are signs that additional stimulus may start to threaten price-level or debt-management stability, or until unemployment falls far enough to make Barro’s multipliers overestimates.)"

Lorenzo Bini Smaghi - "...Keynes’ famous admonition in the last page of his General Theory – according to which “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist” – has been turned upside down. In other words, defunct economists – and their theories – are usually enslaved by practical men who do not fully understand them."

Nick Rowe - "That story makes much more sense (empirically). It's like Okun's "toll model". Firm and worker each have to pay a "toll" (search costs) before the interview. (Like the admission ticket to the disco, but don't push that metaphor too far.) But even if the labour market is perfectly competitive ex ante (before they pay the search costs), there is bilateral monopoly/monopsony ex post, between an individual firm and worker, once those search costs are sunk. So the wage can be anywhere between those two "threat points", and both sides will still want to do the deal. (The "Nash Bargaining Solution" says the equilibrium will be at a particular point, say halfway, between those threat points, but that equilibrium isn't especially compelling, so Roger has ditched it.)

So, take my LRAS/AD picture above, and colour in the *whole area* between the red and blue LRAS curves. It's all one big thick LRAS curve. If we are on one of the two AD curves, and somewhere inside that thick LRAS region, it's an equilibrium. And where in particular we will be, depends on history, animal spirits, Schelling focal points, or whatever."

Stephen Gordon - Ineffectiveness of minimum wages as an anti-poverty measure - "If you want an effective anti-poverty measure, give money to poor people. It really is that simple."

Thursday, February 25, 2010

Bank reserves and the roots of the crisis

Scott Sumner once said that this crisis was caused by economists who were confused over the basics of supply and demand. I believe this is just one half of the story. Economists were also confused over the definition of bank reserves. Textbooks say that bank reserves are liabilities of central bank, by changing the interest rate on reserves central bank can control the money supply. But in modern banking practice a much wider set of assets are reserves that are important in the determination of money supply. This causes two big problems - regulators are unable to correctly apply the money multiplier model in practice and they make serious mistakes. Banking practitioners find money multiplier model unrealistic and are attracted to inferior macroeconomic theories. Fortunately Gary Gorton is coming to the rescue:

"Institutional investors and nonfinancial firms have demands for checking accounts just like you and I do. But, for them there is no safe banking account because deposit insurance is limited. So, where does an institutional investor go to deposit money? The Institutional investor wants to earn interest, have immediate access to the money, and be assured that the deposit is safe. But, there is no checking account insured by the FDIC if you want to deposit $100 million. Where can this depositor go?

The answer is that the institutional investor goes to the repo market. For concreteness, let’s use some names. Suppose the institutional investor is Fidelity, and Fidelity has $500 million in cash that will be used to buy securities, but not right now. Right now Fidelity wants a safe place to earn interest, but such that the money is available in case the opportunity for buying securities arises. Fidelity goes to Bear Stearns and “deposits” the $500 million overnight for interest. What makes this deposit safe? The safety comes from the collateral that Bear Stearns provides. Bear Stearns holds some asset‐backed securities that are earning LIBOR plus 6 percent. They have a market value of $500 millions. These bonds are provided to Fidelity as collateral. Fidelity takes physical possession of these bonds. Since the transaction is overnight, Fidelity can get its money back the next morning, or it can agree to “roll” the trade. Fidelity earns, say, 3 percent.

Just like banking throughout history, Bear has, for example, borrowed at 3 percent and “lent” at 6 percent. In order to conduct this banking business Bear needs collateral (that earns 6 percent in the example) – just like in the Free Banking Era banks needed state bonds as collateral. In the last 25 years or so money under management in pension funds and institutional investors, and money in corporate treasuries, has grown enormously, creating a demand for this kind of depository banking."

Wednesday, February 24, 2010

Loan officer theory of helicopter drop monetary policy

Nick Rowe added a comment to his must-read post about money supply multiplier and keynesian multiplier models:
"I'm going to make just one last point before leaving this topic. It may help clarify a source of disagreement, or (more likely) it may fail totally. But I'm going to make it anyway.

Banks (either individually, or in total) need a lot of different things if they want to expand. Reserves, capital, yes. But also loan officers, computers, tellers, etc. Not to mention people and firms who want to lend or borrow from banks. Why should I "privilege" just one of those many things (reserves)? Why should others "privilege" capital? Aren't the others on the list equally important?

Here's my answer: I privilege reserves because I am interested in the public policy question. The Bank of Canada controls one aspect of public policy (monetary policy), and the Bank of Canada controls the supply of reserves to the banking system. (Again, you can read "the supply of reserves" as either an interest rate (price) or a quantity, but better yet as a functional relationship.) The Bank of Canada does not (except when it bails out banks) directly control the supply of capital, reserve officers, tellers, or anything else."

His comment inspired me to write about the loan officer theory of helicopter drop monetary policy. A good central bank needs two tools - supply of reserves to the banking system and supply of cash to general public using fleet of helicopters.

When commercial banking system is solvent, by controlling the supply of reserves to the banking system, if needed the central bank can cause the expansion of all the things needed for monetary stimulus - solvent banks are ready to hire new loan officers, purchase new computers, increase the number of bank tellers, they can even expand their capital base without any big problems.

The iron law of banking says that it is better to fail conventionally than to succeed unconventionally. This unwritten law was codified in various regulations (Basel, etc.). This means that when banks make mistakes, they repeat them on a system-wide basis. A crisis comes, and the market value of aggregate bank capital falls below the replacement cost. Capital constraint becomes binding. All the bank tellers, loan officers and computers effectively disappear from the monetary transmission mechanism, as stock market is shouting to the banks that they should have hoarded more reserves before the crisis. The only way to break the deadlock is to dispatch the helicopter drops. The helicopter drop policy should be continued until the private sector slowly rebuilds the capital base of the banking system by establishing new good banks.

What is the best way to drop money from helicopters? Nick Rowe once suggested that central banks should buy antique furniture from non-bank public (a must-read link). For me the most important thing that loan officers are incapacitated when banks are insolvent. This means that central bank should soften the blow that is caused by all missing loan officers - i.e. central bank should buy commercial bonds from non-bank public when performing the quantitative easing.

COMING NEXT: How central banks have hijacked the meaning of word "reserves".

WTF?!?! QE R.I.P.

Treasury announcement:

"Treasury anticipates that the balance in the Treasury's Supplementary Financing Account will increase from its current level of $5 billion to $200 billion. This will restore the SFP back to the level maintained between February and September 2009."

This is a de facto end of quantitative easing in the USA. The remaining bit of QE in March will be sterilized by the Treasury. Who could have guessed that Obama administration wants to tighten monetary policy? The fig leaf is provided by WSJ:

"The intention always was to resume SFP issuance when the debt ceiling was increased on a permanent basis, which finally happened earlier this month,” said Lou Crandall, a money market analyst at Wrightson ICAP LLC. “The Treasury kept $5 billion of SFP bills outstanding throughout all the debt limit negotiations as a placeholder to indicate that it wanted to go back to the status quo ante."

Monday, February 22, 2010

Really great links - discount rate cut - contingent capital

John Hussman - "My impression is that the increase in the Discount Rate last week was largely posturing by a Fed that is eager to look prudent in the face of criticism, particularly since Thomas Hoenig, one of the FOMC's own governors, dissented on the most recent move to leave monetary policy unchanged. The good thing about the Discount Rate hike, from my perspective, is that it gives the Fed a costless way to respond to any fresh credit difficulty, at which point (as it did in 2007), it will now have the option of cutting the rate by 50 basis points some morning when the market appears prone to panic. Not that such a move is likely to have more than a psychological effect, but it does provide one more tool to use when responding to any fresh credit issues."

David R. Kotok on discount rate cut - "But the Fed has now added an uncertainty premium and markets are adjusting to it. That means somewhere, some mortgage will not get refinanced. And somewhere, some bond financing will cost more to accomplish. And somewhere, some US manufacturer who exports will face a headwind because the dollar is stronger and his foreign competitor can sell more cheaply than yesterday. And somewhere, some person is not going to get hired because this uncertainty has raised the risk of hiring to the employer."

Robert Shiller on financial engineering - "Contingent capital, a device that grew from financial engineering, is a major new idea that might fix the problem of banking instability, thereby stabilizing the economy – just as devices invented by mechanical engineers help stabilize the paths of automobiles and airplanes. If a contingent-capital proposal is adopted, this could be the last major worldwide banking crisis – at least until some new source of instability emerges and sends financial technicians back to work to invent our way of it."

Paul Krugman - A Globalization Puzzle - "But what becomes clear once you think about it is that what matters is technological progress in transport relative to other activities. Double productivity across the board — cloth and wine as well as transport — and trade remains not worth it. It’s not at all obvious, then, that over the long run technological progress should always lead to increased trade as a share of gross world product.
So, how do we make sense of long-run trends in globalization?
I have a story about 1870-1913: it’s all about steam. Steam engines were the big technological change of the era, and they were inherently biased toward transportation: steam power had lots of uses, but none so compelling as railroads and ships.
I also, sort of, have a story about the interwar period. That was, arguably, an era in which the big things were electricity and internal combustion. And while both of these mattered a lot for short-haul transportation, they didn’t do much for long-range shipping. Meanwhile, electrification of factories was producing big productivity gains, and so perhaps was motorized farm machinery. So technology had an anti-trade bias. (?)"

Really great links - equity premium puzzle - consumption in China - brain drain

From the archives of Xavier Gabaix and David Laibson - The 6D Bias and the Equity-Premium Puzzle - Consumption growth covaries only weakly with equity returns, which seems to imply that equities are not very risky. However, investors have historically received a very large premium for holding equities. For twenty years, economists have asked why an asset with little apparent risk has such a large required return. Grossman and Laroque (1990) argued that adjustment costs might answer the equity-premium puzzle. If it is costly to change consumption, households will not respond instantaneously to changes in asset prices. Instead, consumption will adjust with a lag, explaining why consumption growth covaries only weakly with current equity returns. In Grossman and Laroque’s framework, equities are risky, but that riskiness does not show up in a high contemporaneous correlation between consumption growth and equity returns. The comovement is only observable in the long run.

Paolo Pellegrini - "And while many pin their hopes on China, that country is still primarily growing its investment spending, not its consumption. It will be very difficult for the Chinese leadership to let consumption take off because a subsequent slowdown would be politically destabilizing."

Arnold Kling/Laura Freschi - Brain drain - "Even using official figures, which likely far undercount the value of remittances by excluding informal channels, remittances sent back by Africans abroad outweigh the cost of educating them at home. Why pass up a high return opportunity (Africans earning high incomes abroad and remitting) and insist on a low return activity (educated Africans underemployed at home)?"

The Reformed Broker - Soros Still Enamoured With Paulson Picks - "One of my favorite anecdotes from the book The Greatest Trade Ever was when John Paulson heads up to George Soros' offices for a light lunch and a heavy discussion of how Paulson's real estate/ mortgage crash trade was conceived and constructed. It seems that Soros continues to follow his new friend into positions and trades."

Friday, February 19, 2010

Fed raises discount rate - big mistake

Fed raised the discount rate. Most probably this is a big mistake. Quick and dirty attempt at a charitable interpretation of the rate hike:

  • Stability of short term nominal interest rates is overrated. This hike can be easily reversed in future.
  • This is a price Bernanke has paid for keeping Fed funds rate at near zero for an extended period.
  • This is a price Bernanke has paid for not reversing QE.
  • This is just a way to have a tiny symbolic tightening without restarting the interest rate cycle 

More worryingly, this action again confirms that Fed believes that manipulation of short term risk free interest rates is all that we need to ensure economic recovery.

Thursday, February 18, 2010

Rates strategy - FOMC Minutes - Fed hawks paint themselves into a corner

Key takeaways from FOMC minutes that were released yesterday:

  • 2010 GDP forecast revised to 2.8-3.5% from 2.5-3.5%. After stimulus and inventory rebuild fades, actual 2010 data will be at least a bit softer than average forecast and Fed hawks will be in a very uncomfortable position. Extended period of exceptionally low levels of the federal funds rate will last longer than many think.
  • 2012 core CPE inflation forecast is just 1.0-1.7%, previously 1.2-1.9%. This supports our view that median FOMC member is still dovish and all the noise about the tightening is just an opinion of loud minority. 
  • Bulldog fight under a carpet regarding the asset sales. Bernanke has failed to spread the coherent vision of quantitave easing theory to his fellow FOMC members. Only a minority has a conviction that QE is a necessary tool during the credit crisis: "A few suggested that the pace of asset sales, and potentially of purchases, could be adjusted over time in response to developments in the economy and the evolution of the economic outlook." The median FOMC member still believes the misguided notion that manipulation of short term risk free interest rates is all it takes to come out of the crisis, this misjudgement has seriously negative implications for risk assets.

Thursday, February 11, 2010

John Hussman's extreme inflation forecast. Will the CPI double over the next ten years?

John Hussman runs the very successful $6.7 billion Hussman Strategic Growth Fund. I greatly admire Hussman's investment and risk management skills, so I was really surprised when I saw his inflation forecast:
At present, inflation risks are hardly considered to be problematic by Wall Street. From the standpoint of the next few years, my impression is that this complacency is probably well-founded, but only because we are likely to observe a second wave of credit losses that will create fresh "safe-haven" demand for default-free government liabilities. From a longer-term perspective, however, I believe that inflation will be a major event in the latter part of the coming decade, with the consumer price index roughly doubling over the next ten years. As exchange rates and commodity prices tend to be more forward-looking and less "sticky" than the prices of goods and services, it is likely that these markets will move substantially well before the eventual peak in CPI inflation.

John Hussman says government spending growth is the key driver of inflation and presents us with this chart:
Hussman uses quantity theory of money in his work, and prefers to use quantity of all government liabilities as his measure of money supply. Hussman observes the enormous increase of government liabilities during the crisis, and he sees no end of this process. He is worried about the doubling of the monetary base, he is worried about the cost of bailout of bondholders of insolvent financial institutions and he is worried of the nationalization of mortgage market. John Hussman says that likely near term worsening of the credit crisis will increase deflation concerns, but long term inflationary picture has a very strong foundation:
The past two years have seen an enormous issuance of new government liabilities. During the two years ended September 30, 2009, the amount of U.S Treasury debt held by the public (outside of agencies such as the Social Security Administration and the Federal Reserve) surged by more than 50%, from $5.05 trillion to $7.55 trillion. During that time, the Fed's holdings of U.S. Treasuries actually shrank by about $10 billion, yet the Fed has explosively increased U.S. monetary base from $850 billion to $2.02 trillion, fueled by massive purchases of Fannie Mae and Freddie Mac's mortgage-backed securities.
I think that the doubling of the CPI over the next ten years is very unlikely. First, Hussman's scenario of inflationary fire after deflationary flood is too specific. It is difficult enough to identify the most probable events for the next few years and any additional specific details quickly diminish the probability forecast is correct. Second, by saying there is a huge risk of second wave of credit concerns, Hussman basically admits that the current fiscal and monetary policy stance is appropriate for the next few years.

Third, the return of significant inflation means that the intrinsic value of MBS is near par again, and the real budgetary cost of bailouts is low. Fourth, at the first sign of increased inflation in the actual data FOMC hawks will be able to tighten monetary policy. Timothy Geithner's extended Fannie and Freddie funding commitment will allow Fed to shrink the monetary base without big pain. Fifth, fiscal hawks in the Congress will prevent the worst forms of fiscal incontinence.

Sixth, Hussman has repeatedly stated he thinks Fed's monetary policy has no effect, because higher fed funds rates have no effect because they pressure monetary velocity higher. This is just a classic case of confusing correlation with causation.

Don't get me wrong - I completely agree with Hussman that the current stimulus is of the wrong kind. It is just that any stimulus is better than none when the risk of deflationary spiral is still looming ahead. And I am also confident that Hussman will wait for very attractive entry points for commodity positions needed to hedge the inflation risks he sees.

Wednesday, February 10, 2010

Unusual for an academic economist, Karl Smith understands Lehman

Karl Smith:
Perhaps, unusual for an academic economist, I watched the crisis unfold in real time.
He watched the Lehman crash and he understands the crisis:
Certainly, at the time it seemed that fragility was the issue. However, I would go further and say it wasn’t just that the government didn’t bail Lehman out, it was that Lehman experienced what looked like a run. Moreover, it seemed at the time that the run was spreading. The money markets were reportedly in turmoil.There was a rumor that Wachovia was offering 30% APR to roll over 7 day paper and could not find a buyer. From my perspective it seemed as if a liquidity crisis might be enveloping all of the major financial institutions in the United States. So much so, that warned my colleagues and contacts that we were “walking a fine line.” And, it was not inconceivable that the entire global transactions infrastructure was going to come undone. <...>
Instead, I at least, felt a general sense that actually bankruptcy and short term creditor losses just “weren’t going to be allowed to happen.” I am not sure exactly what I would have been expecting. Whether that meant a last minute buyer pressured by the Fed, or action by the Treasury or even something as fanciful as a private consortium of banks swooping in, in an effort to stave off systemic collapse, I can’t say. The fact that nothing happened, however, was a shock.

Related post: Total Failure: Ben Bernanke's First Term

Thursday, February 4, 2010

Answer to Scott Sumner

Scott Sumner discusses the EMH:
The commenter 123 sent me a link to an article by Andrei Shleifer, which argues that markets aren’t efficient.
You have to be impressed by the resourcefulness of the anti-EMH, crowd. If LTCM and its merry band of Nobel-Prize winning economists had actually beat the market, if they had used market anomalies to get rich, well then it would have been the death knell of the EMH. Every time Fama said “if you’re so smart how come you’re not rich,” people would have responded that Scholes and Merton did get rich by spotting market inefficiencies. Instead they failed miserably, and this shows . . . it show that markets are inefficient because the market can stay irrational longer than you can stay solvent.
OK everyone, tell me where I’m wrong. What outcome of LTCM’s bet on Shell Oil would have supported the EMH?
It is very simple. If LTCM's bet on Shell was successful, the market would be less inefficient than before that bet, and EMH would be a little bit less wrong than before. As we know LTCM had to liquidate Shell Oil arbitrage position, and their attempt to improve the efficiency of markets was unsuccesful. There is no paradox at all - any outcome of LTCM's bet on Shell Oil would have supported neither EMH nor the theory of phlogiston.

The Money Demand