Alt-M http://www.alt-m.org Ideas for an Alternative Monetary Future Fri, 24 Jun 2016 13:27:27 +0000 en-US hourly 1 http://wordpress.org/?v=4.1.12 Friday Flashback: Free Banking and Classical Liberalism, a Potted History http://www.alt-m.org/2016/06/24/friday-flashback-free-banking-and-classical-liberalism-a-potted-history/ http://www.alt-m.org/2016/06/24/friday-flashback-free-banking-and-classical-liberalism-a-potted-history/#comments Fri, 24 Jun 2016 13:13:57 +0000 http://www.alt-m.org/?p=47208 (It occurred to us that some of our early posts, and especially ones from Alt-M’s predecessor, Freebanking.org, may deserve a new airing, as they remain pertinent, but haven’t been seen by many of our newer readers.  With that in mind, we’re pleased to introduce Friday FLASHBACKS: an occasional weekend dip...

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(It occurred to us that some of our early posts, and especially ones from Alt-M’s predecessor, Freebanking.org, may deserve a new airing, as they remain pertinent, but haven’t been seen by many of our newer readers.  With that in mind, we’re pleased to introduce Friday FLASHBACKS: an occasional weekend dip into our archives.  Enjoy!)

Oresme new with captionSkipping over ancient thinkers, early modern expressions of classical liberal thought on money may be found in the writings of Nicholas Oresme and other Scholastics who denounced the sovereign’s debasement of the coinage as a dishonest and tyrannical, a violation of the sanctity of contract that a just sovereign must respect.  David Hume in the 1750s refuted the Mercantilist fear that unless the sovereign interfered with freedom of trade and payments the nation’s economy would retain too little silver and gold.  Adam Smith in 1776, and later defenders of free banking in Britain, on the Continent, and in the Americas (my favorite being William Leggett), applied free-trade doctrines to banking and bank-issued currency.  Thomas Hodgskin and Herbert Spencer even dared to defend private coinage.  Walter Bagehot defended the principles of free banking, though he thought it a lost cause politically.  In the twentieth century the Austrian economist Ludwig von Mises gave new subtlety and rigor to the case for free banking.  Friedrich Hayek made somewhat ambivalent cases for gold and free banking earlier in his career, but in the 1970s forcefully called for Choice in Currency and The Denationalisation of Money.  Free banking as a policy ideal is the result of applying the norms of classical liberalism to money and banking.  Classical liberalism upholds individual liberty and private property rights, including freedom of contract, under the rule of law.  It opposes rule by unconstrained authorities.

Many leading classical liberals over the centuries, however, have failed to apply their free-trade principles consistently to money.  David Ricardo favored nationalization of coinage and banknote issue, and the forced substitution of redeemable paper notes for coins in all but the largest payments.  John Cobden, the free trader, supported the nationalization of banknotes.  After the Second World War, most of the German Ordoliberals and the Monetarists, led respectively by Walter Eucken and Milton Friedman, made peace with central banking and fiat money.  (Although Friedman, it should be noted, reconsidered his position in the 1980s and began favoring free banking and the abolition of the central bank.)  The otherwise radically free-market theorist Murray Rothbard favored a 100% reserve requirement, with no allowance for capitalist acts among mutually consenting adults who want to contract around that rule.  Alternatives to fiat money, central banking,  and deposit insurance were not on the program of the Mont Pelerin Society, a leading international society of classical liberal intellectuals, at its special meeting to discuss the financial crisis in 2009.

A century ago, before the First World War, economic classical liberals almost unanimously supported the ideals of the international gold standard.  The “classical” period of the gold standard is usually dated from the United States’ resumption of gold payments in 1879 until the suspensions of payments in the First World War.  The gold standard was fatally wounded in the First World War and never fully recovered.  In practice it had not been a completely market-regulated system even before the war.  National governments had long banned market competition in coining by giving themselves a monopoly in the minting of coins.  Many similarly banned market competition in the issue of gold-backed banknotes and gave a monopoly to a government-sponsored central bank.  National central banks violated the “rules of the game” by interfering with, overriding, or suspending the automatic operation of international gold flows.  The centralization of gold reserves, a characteristic feature of central banking, altered the operation of the international gold standard for the worse.

Nonetheless the classical gold standard more nearly approached a self-regulating international monetary system than anything that has followed.  Monetary nationalism and monetary statism since the First World War has brought us to our present system of national fiat monies, central banking, and extensive government interference in financial markets everywhere in the world (with the exception of offshore banking havens).  The global financial crisis that began in 2007 has exposed the weakness and non-self-regulating character of the present system for all to see.

Our challenges for the present day, and for this blog, are to discover how we might reform the system in manner consistent with the ideals of freedom.  How might we restore healthy self-regulation to our local and international monetary and banking systems?

Here are some references for the above history, which may also begin to answer Brad Jansen's request for recommendations of classic readings.

Nicholas Oresme, De Moneta (Of Currency) [c. 1355], translated by Charles Johnson, in Lawrence H. White, ed., The History of Gold and Silver (London:  Pickering and Chatto, 2000), vol. 1;  David Hume, “Of the Balance of Trade,” in Essays, Moral, Political, and Literary, ed. Eugene F. Miller (Indianapolis:  Liberty Fund, 1987); Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, ed. R. H. Campbell, A. S. Skinner, and W. B. Todd. (Oxford: Oxford University Press, 1976); Vera Smith, The Rationale of Central Banking [1936] (Indianapolis: Liberty Fund, 1990); William Leggett, Democratick Editorials (Indianapolis: Liberty Fund, 1984); Thomas Hodgskin, Popular Political Economy (London: Charles Tait, 1827); Herbert Spencer, “State-Tamperings with Money and Banks,” in Essays Scientific, Political and Speculative, vol. 3 (London:  Williams and Norgate, 1891); Ludwig von Mises, The Theory of Money and Credit [1912] (Indianapolis:  Liberty Fund, 1980); Mises, Human Action, 3rd ed. (Chicago: Henry Regnery, 1966); F. A. Hayek, Choice in Currency (London: Institute of Economic Affairs, 1976); Hayek, Denationalisation of Money, 2nd ed. (London:  Institute of Economic Affairs, 1978).  David Ricardo, Plan for the Establishment of a National Bank [1824] in The Works and Correspondence of David Ricardo, ed. Piero Sraffa with the Collaboration of M.H. Dobb (Indianapolis: Liberty Fund, 2005),vol. 4, Pamphlets and Papers 1815-1823;  Richard Cobden in 1840 Parliamentary testimony cited by Lawrence H. White, Free Banking in Britain, 2nd. ed (London: Institute of Economic Affairs, 1995), p. 84; Walter Eucken, Grundsätze der Wirtschaftspolitik (Tübingen:  J. C. B. Mohr, 1952); Milton Friedman, A Program for Monetary Stability (New York:  Fordham University Press, 1960); Friedman,  “Monetary Policy for the 1980s” in John H. Moore, ed., To Promote Prosperity(Stanford: Hoover Institution Press, 1984); Murray N. Rothbard, “The Case for a 100 Percent Gold Dollar” in Leland Yeager, ed., In Search of a Monetary Constitution (Cambridge, MA: Harvard University Press, 1962).

[This article originally appeared at Freebanking.org, the predecessor site to Alt-M.org, on June 4, 2011]

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Yes, the Federal Reserve has a Diversity Problem http://www.alt-m.org/2016/06/23/yes-the-federal-reserve-has-a-diversity-problem/ http://www.alt-m.org/2016/06/23/yes-the-federal-reserve-has-a-diversity-problem/#comments Thu, 23 Jun 2016 13:12:28 +0000 http://www.alt-m.org/?p=46864 Federal Reserve Chair Janet Yellen recently appeared before the Senate Banking Committee to deliver the Semiannual Monetary Policy Report to the Congress.  A handful of Senators queried Yellen as to the lack of diversity among both the Fed staff and the members of the Federal Open Market Committee (FOMC). Here,...

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Federal Reserve White MenFederal Reserve Chair Janet Yellen recently appeared before the Senate Banking Committee to deliver the Semiannual Monetary Policy Report to the Congress.  A handful of Senators queried Yellen as to the lack of diversity among both the Fed staff and the members of the Federal Open Market Committee (FOMC).

Here, for example, is the exchange between Senator Warren and Yellen (paraphrased, as I heard it):

Warren: Diversity is very important.  Studies show gender diversity in leadership makes for stronger institutions.  I’m not surprised there’s a stunning lack of diversity at our biggest financial institutions.  The Fed’s leadership diversity is somewhat better, but not a whole lot better. … Does lack of diversity among regional Fed presidents concern you?

Yellen: Yes, I believe it’s important to have diverse groups of policy makers who can bring different perspectives to bear.  It is the responsibility of regional banks’ Class B and C directors to to conduct a search and identify candidates for regional Fed presidents.  The Board reviews those candidates and we insist the search be national and every attempt is made to identify a diverse pool of candidates.

Warren: But what about the outcome?  When a new regional Fed president is selected by the regional Fed board that person must be approved by you and others on the Board of Governors before taking office.  The Fed Board recently reappointed each and everyone of these presidents without any public debate or any public discussion about it.  If you’re concerned about diversity, why didn’t you use these opportunities to say enough is enough?  Let’s go back and see if we can find qualified regional presidents who also contribute to the overall diversity of the Fed’s leadership?

Yellen: Well we did undertake a thorough review of the reappointments … [etc., etc.]

Warren: [Interrupting] But you’re telling me diversity’s important and yet you just signed off on all these folks without any public discussion about it. … The selection process is broken. Congress should take a hard look at reforming the regional Fed selection process so that we can all benefit from a Fed leadership that reflects a broader array of backgrounds and interests.

While it is tempting to dismiss such questions as mere identity politics (I’m waiting for Trump to complain about bringing in the Fed Vice Chair from Israel), the Fed has increasingly over time come to look less and less like the rest of America.

Should this matter, at least in terms of monetary policy?  I believe it should.  We are a big country and, despite a focus on national aggregates, different parts of the country experience different economic conditions.  California isn’t Texas; nor is it Ohio or New York.  To some extent these regional differences are why we have the convoluted regional structure of the FOMC.  Different voices can bring their experiences and local knowledge to bear in a manner that should result in a monetary policy that weighs the conditions of both New York and Ohio (as well as the rest of the country).  Researchers have found that local economic conditions do indeed influence voting behavior on the FOMC.  The finding holds not just for the regional bank Presidents, but also for Fed governors.

Of course geography is only one element.  Having Fed leadership from different segments of our society, as well as different disciplines, encourages multiple approaches to problem-solving.  While I am an economist and see a lot of value in economics, I’d be the first to say economics doesn’t have all the answers.  Similarly, bankers can have important insights into the functioning of the economy, but so can manufacturers, retailers and farmers.

A greater variety of backgrounds could also improve Fed communications.  Spending a lot of time around economists, I think it is fair to say we often speak a different language, sometimes foreign and strange to outsiders.  A Fed board where deliberations occur across disciplines could improve the explanations of those deliberations to the broader public.  I know I’ve often learned a considerable amount of economics in the process of trying to explain something to non-economists.

It is perhaps for this reason that Section 10 of the Federal Reserve Act requires that

In selecting the members of the Board, not more than one of whom shall be selected from any one Federal Reserve district, the President shall have due regard to a fair representation of the financial, agricultural, industrial, and commercial interests, and geographical divisions of the country.

Despite the clear language of Section 10, since 1996 80 percent of Fed governors have come from the East Coast (which has only about 30 percent of the population).  The chart below shows successful nominees and the Federal Reserve district they were connected with, as viewed by the President who nominated them, the Senate who approved them, and the district of the nominees birth.  The fact is we are not getting a monetary policy reflecting the perspectives and needs of the entire nation, but rather one concentrating on those of New York and Washington (which falls in the Richmond district).

Calabria 1 Cropped

To some extent the heavy concentration of appointments to the Board from NY, Boston and DC reflects the revolving door between the Fed, the financial industry and the executive branch (particularly the Treasury and the Council of Economic Advisors).  So the lack of diverse perspectives is likely even worse than it seems.  Not only do Fed appointments reflect biases favoring New York, but predominately biases favoring New York’s financial industry.  Similarly, for Washington, appointments reflect biases favoring the Treasury department or the status quo thinking in monetary economics.

As both The Wall Street Journal and the Harvard Business Review have noted, the FOMC has come to be dominated by academic economists.  Josh Zumbrun observed in 2015:

Of the 17 Fed officials in office next year—five members of the Board of Governors and 12 regional bank presidents—all but three will have professional backgrounds as academics or with Goldman Sachs.  The exceptions will be Atlanta Fed President Dennis Lockhart and Fed governor Jerome Powell, who worked at other banking institutions, and Kansas City Fed President Esther George, who was primarily a bank supervisor.

About 70 percent of Fed Board members and regional Presidents were once either Fed economists or academics:

Calabria 2

Educational background of FOMC’s members has also become more concentrated around PhDs in economics:

Calabria 3

Additionally, Fed economists themselves are heavily concentrated among the graduates of a handful of graduate programs:

Calabria 4

Don’t get me wrong.  A couple of smart economists with degrees from MIT, who have lived most of their lives in either Boston, New York or DC, are certainly able to contribute to monetary policy.  But when the entire system starts to consist of individuals from the same small number of cities, who graduated from the same schools and studied the same disciplines, then “yes” we have a problem.  You are guaranteed to have an institution that suffers deeply from groupthink, as well as being insulated from the everyday experiences of most Americans.

Senator Warren suggests that “the selection process is broken.”  I couldn’t agree more.  To repair it, we must first recognize that the choice of Fed Board members begins with the President.  At a minimum the President should faithfully follow the considerations spelled out in Section 10 of the Federal Reserve Act.  If he fails to do so, as was the case with the nomination of Peter Diamond, the Senate is obligated to reject that nomination.  While Diamond’s case was clear, previous nominations have been less so.  To provide some clarity, I would suggest that Congress amend Section 10 to list specific conditions determining residency.  I believe a minimum of ten years actual residency should be the requirement for a nominee to be “from” a particular Fed district.

Congress could put additional limitations on Board appointments to increase diversity.  For example, amending Section 10 to state that no more than two board members may come from any one of “finance, manufacturing, agriculture, government or academia” would reduce groupthink and likely increase the quality of decision-making at the Fed.  Slowing the revolving door between the Fed, Treasury and finance could also increase diversity.  I would suggest we ban from consideration for Fed nomination anyone who has served in the executive branch in the previous six years and impose a similar ban for those working for institutions regulated by the Fed.

Having worked on Fed nominations as a staffer for the Senate Banking Committee, I’d be the first to say that the Senate has too often rubber-stamped a President’s Fed nominees.  Recent years have witnessed an improvement in Senate due diligence, but far more needs to be done.  Changes in the norms behind Senate consideration may not be durable.  Accordingly changes to the selection process for the FOMC are badly needed.  I agree with Sen. Warren, the Fed needs leadership with a “broader array of backgrounds and interests.”  Which means the definition of diversity must also include geographic diversity, educational diversity, and diversity of professional experience.  The quality of monetary policy-making depends on it.

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On the Road http://www.alt-m.org/2016/06/22/on-the-road/ http://www.alt-m.org/2016/06/22/on-the-road/#comments Wed, 22 Jun 2016 13:17:45 +0000 http://www.alt-m.org/?p=46522 If you haven't heard much from me on these pages of late, it's because I spent most of the last two weeks traveling back and forth, and so had little time for blogging. I did, however, participate in some interesting events while I was away.  The first of these was...

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Zurich CompressedIf you haven't heard much from me on these pages of late, it's because I spent most of the last two weeks traveling back and forth, and so had little time for blogging.

I did, however, participate in some interesting events while I was away.  The first of these was "Futures Unbound," the second installment so far of Cato's annual Summit on Financial Regulation, held at the Drake Hotel in Chicago on June 6th.  I gave a talk there on the regulatory role of private clearinghouses.  I also had the pleasure, the night before, of taking part in a speakers' dinner that was also attended by two distinguished (and very fun!) members of the CMFA's Council of Academic Advisors, George Kaufman of Loyola University Chicago and Randy Wright of the University of Wisconsin.

After the Chicago event I headed straight to London, where I'd been invited to give the Institute of Economic Affairs' annual Hayek Lecture.  Before the lecture Philip Booth, the Institute's Editorial and Programme Director, interviewed me briefly on the necessity of central banks.  The main event took place that evening at Church House, a few blocks away from the IEA's offices in Westminster; and I was pleased to find that in arranging for that commodious venue the Institute hadn't overestimated the audience for my topic, which included many good friends from all over Europe.

Alas, much as I would have liked to linger with that crowd, I had to be whisked away, first for some dinner, and thence to a Heathrow hotel, where I could rest a little before catching an early flight to the States, where I took part in the second in what I hope will be a long-lived series of Liberty Fund conferences co-sponsored by them and Cato's Center for Monetary and Financial Alternatives. This one, on "Liberty and Currency: The U.S. Asset Currency Reform Movement," took place (appropriately enough) on Jekyll Island, under the direction of CMFA Adjunct Scholar (and occasional Alt-M contributor) Jeff Hummel,  with David Henderson serving as discussion leader. The other distinguished participants included Rutgers' Hugh Rockoff and U.C.S.D.'s Lawrence Broz. Like every other Liberty Fund conference I've attended, this one was great fun. Unfortunately, it's unbuttoned proceedings were so in part (as is also always the case) because they were both confidential and unrecorded, so I'm unable to share any part of them with you.*

After Jekyll Island it was across the Atlantic again, this time to Zurich, where I took part in the ETH Risk Center's conference on "Alternative Financial and Monetary Architectures."  Others who spoke there included William R. White, another member of the CMFA's Council of Academic Advisors, as well as "Limited Purpose Banking" champion (and write-in U.S. presidential candidate) Laurence Kotlikoff.  Although this event's proceedings were also not recorded, the ideas I presented were a somewhat modified version of ones I presented at a Cato Monetary Conference a few years ago.

After the Zurich conference, I lingered for a day in Zurich, where I was able, by sheer luck, to dine with Cato Senior Fellow Jerry O'Driscoll, who happened to be on his way to an event in Lichtenstein. That dinner was a splendid and relaxing conclusion to a sometimes taxing itinerary — and the next-best thing to being back home again, with my very best friend.

Penelope compressed

________________________

*Those interested in taking part in future Liberty Fund-CMFA events are encouraged to write to me expressing their interest.  Please note, however, that these events are generally open only to academics and other holders of graduate degrees.

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The Case Against Dodd-Frank http://www.alt-m.org/2016/06/17/the-case-against-dodd-frank/ http://www.alt-m.org/2016/06/17/the-case-against-dodd-frank/#comments Fri, 17 Jun 2016 13:12:55 +0000 http://www.alt-m.org/?p=46174 The Heritage Foundation recently released a policy book, The Case Against Dodd-Frank: How the Consumer Protection Law Endangers Americans.  The book consists of a title-by-title examination of Dodd-Frank, with each book chapter more or less corresponding to one of Dodd-Frank’s titles.  CMFA’s Mark Calabria and Thaya Brook Knight both contributed,...

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The Case Against Dodd-FrankThe Heritage Foundation recently released a policy book, The Case Against Dodd-Frank: How the Consumer Protection Law Endangers Americans.  The book consists of a title-by-title examination of Dodd-Frank, with each book chapter more or less corresponding to one of Dodd-Frank’s titles.  CMFA’s Mark Calabria and Thaya Brook Knight both contributed, with Calabria writing on deposit insurance (Title III), payday lending (Title XII), and mortgage finance (Title XIV and Title IX Subtitle D).  Calabria and Knight co-wrote a chapter on credit rating agencies and executive compensation (Title XI).

The book is particularly helpful because of its “problems and solutions” format, dissecting the problems of a specific section or title of Dodd-Frank, and then offering a plan policymakers can take to revise it.  Of course, the solutions presented are second-best, at best.  In our legislative system, shrinking the size of the regulatory state is much more difficult than growing it.  When such beneficial shrinking does occur, it tends to be piecemeal.  The solutions posed here are attuned to this reality.

The book offers a convenient chapter-by-chapter summary in its introduction, along with 10 principles governing the authors’ reform proposals.  But let’s highlight a few topics of particular salience to Alt-M: deposit insurance, mortgage securitization provisions, and Federal Reserve emergency lending.

Deposit Insurance

What makes deposit insurance so destabilizing?  Mark Calabria argues that depositors have no incentive to closely scrutinize their bank’s capital holdings and investment activity.  Consequently, bank managers do not have to worry that excessive risk taking will drive them away.

One doesn’t have to be a limited government advocate to realize that deposit insurance harms bank stability.  Even President Franklin Roosevelt was a vocal opponent.  When considering the Glass-Steagall bill in 1933 that contained the FDIC, he commented that deposit insurance “would lead to laxity in bank management and carelessness on the part of both banker and depositor.”

Empirical evidence confirms the moral hazard problem of deposit insurance.  Comparing the Canadian versus American banking system in the 1920s and 30s, Calabria notes that the Canadian system, with no insurance, suffered only one failure, while the American system, with its state-based system of deposit insurance at the time, suffered 6,000 bank suspensions in the 1920s alone — the worst failures being in states with the most generous insurance systems.  A current World Bank study of 150 countries found that the more generous a country’s deposit insurance, the more frequent that country faced banking crises, all else equal.

Dodd-Frank is likely to expand the share of insured, relative to uninsured, deposits among banks by changing how FDIC fund premium payments are calculated.  Before Dodd-Frank, the premiums banks paid into the fund were based on the total amount of the bank’s liabilities covered by deposit insurance.  Now, the premiums are based on a formula: total assets minus total tangible equity.  The old formula encouraged banks to cautiously fund operations using debt or uninsured deposits; the new formula favors using insured deposits thereby “increasing moral hazard and placing the deposit insurance fund at ever greater risk.”

How can policymakers fix the mal-incentives of Dodd-Frank’s Section 331?  Calabria believes that the first step is reducing the deposit insurance cap from $250,000 to the pre-1980 limit of $40,000.  Given that the median dollar amount held in a U.S. checking account is $4,000 and the median for a certificate of deposit account is $16,000, federal insurance would still cover most depositors — a politically palatable proposition.  The reduced cap, however, would restore some market discipline by encouraging larger deposit holders to become more informed about where they place their funds.

Mortgage Finance

Calabria also writes sections on mortgage and housing policy.  A popular view after the crisis was that mortgage securitization allowed mortgage originators to make overly risky loans and then embed the risk deeper in the financial system via MBS.  But Calabria points out, the buildup in securitization in the decades preceding the crisis is better understood as regulatory arbitrage resulting from the Basel capital standards’ relatively low risk weight for mortgage debt.

To curb securitization, Subtitle D of Dodd Frank’s Title IX introduced a provision requiring mortgage issuers to maintain “not less than five percent of the credit risk” for any loan that fell outside of the newly created “qualified residential mortgage” (QRM) safe harbor.  While this provision, known as risk retention, won’t improve lending practices or financial stability, Calabria demonstrates that it will increase costs.

The provision that creates the QRM safe harbor standard is actually an amendment to the 1934 Securities Exchange Act, meaning that issuers of MBS retrospectively found to be containing non-QRM mortgages would be subject to the SEC rule 10b-5 prohibition against fraud.  This liability will “increase documentation and verification costs, which will ultimately be passed on to borrowers.”

Because Subtitle D of Title IX attaches “increased liability to any violation" of its mandated solutions for resolving conflicts of interest, rather than removing "artificial incentives for securitization,” Calabria favors a full repeal.  Short of that, he suggests creating a simpler standard for risk retention, requiring it only for pooled subprime mortgages.  Calabria also urges policymakers to reconsider the risk weight system actually responsible for encouraging excess investment in risky MBS.

Emergency Lending

Heritage's Norbert Michel covers Section XI of Dodd-Frank, which attempts to restrict the Fed’s emergency lending powers.  Michel shows how the Fed has consistently abused both the discount window and Section 13(3) emergency lending, issuing loans not justified by Bagehot’s classic lender of last resort principles.

In 1974, the Fed provided six months worth of discount window loans to the failed Franklin National Bank.  In 1985, it lent to the failed Continental Illinois for a full year.  Of the 530 depository institutions that failed from 1985-1991, sixty percent had outstanding discount window loans, valued at $8 billion in total.  Of course, the largest instances of questionable Fed lending occurred during the recent crisis.  The Fed lent $16 trillion; generally at below market rates, against suspect collateral, and to firms of questionable solvency.  According to Michel, the Fed served as a “source of subsidized capital,” rather than a true last resort lender.

Section XI of Dodd-Frank amended 13(3) to allow emergency loans only if such loans had “broad based eligibility,” and to prohibit such loans from being extended to insolvent borrowers.  Unfortunately, Dodd-Frank lets the Board of Governors make the rules defining “broad based” and “insolvent,” and their definitions do not amount to much of a restriction. Instead, Michel proposes both revoking Section 13(3) and closing the discount window entirely, to restrict Fed lending to broadly accessible open markets operations (OMO) only. As a complement, Michel advocates ending the primary dealer system, allowing all Fed member banks to directly participate in OMO, further ensuring Fed policymaking does not serve as de-facto preferred credit allocation.

Again, find complete online text of The Case Against Dodd-Frank here.  And you can also check out a special event with several of the book’s authors next week at The Heritage Foundation; registration and live stream info here.

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Buiter on the Politics of Normalization http://www.alt-m.org/2016/06/14/buiter-on-the-politics-of-normalization/ http://www.alt-m.org/2016/06/14/buiter-on-the-politics-of-normalization/#comments Tue, 14 Jun 2016 13:04:03 +0000 http://www.alt-m.org/?p=44266 The most stinging rebuke, as well as the  most public one, I ever received over the course of my academic career, was delivered to me in the pages of The Economic Journal.  It consisted of a  footnote to an article celebrating James Tobin's contributions to economics.  The footnote offered a...

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WillemBuiterThe most stinging rebuke, as well as the  most public one, I ever received over the course of my academic career, was delivered to me in the pages of The Economic Journal.  It consisted of a  footnote to an article celebrating James Tobin's contributions to economics.  The footnote offered a paper of mine, also published in the EJ, as a "striking example" of the "comeback" of models relying upon "ad-hoc, backward-looking, mechanical expectation formation models of the early 1960s…in the guise of adaptive learning rules."

What made my example especially egregious, in my chastiser's  view, was the fact that, though I referred to "adaptive learning," my argument was mainly couched in terms of static expectations — an especially naive sort.  To make matters worse, in defending my method, I referred to some other works that seemed to me to supply a rationale for such "naive" thinking in certain contexts.  By so doing, it seems, I was treating "appeal to higher authority (Marx, Keynes, Lucas etc.) [as] an acceptable substitute for empirical evidence or logical argument starting from reasonable primitive assumptions," thereby supplying "evidence of the immaturity of economics as a science."  Ouch!

In my defense, my topic was the transition from barter to fiat money, and despite the upbraiding I received I still think it perfectly reasonable to assume that, when some new technology is about to make its appearance, and especially when the first stages of its development are for the most part imperceptible (and money surely qualifies as such a technology), its development is likely to be quite unexpected.  And I didn't assume static expectations for the heck of it, or because I didn't realize that doing so was passé.  I assumed them in order to draw attention to their instrumental value and, hence, their possible relevance.  When static expectations or any of their somewhat more sophisticated counterparts, including adaptive learning, were assumed to operate in a monetary search framework, that framework yielded predictions much more consistent with historically-observed patterns of monetary development than it did if expectations were instead assumed to be forward-looking and, in that sense, "rational."

But my main reason for bringing that whole business up isn't so that I can defend my poor old article.  It's to draw attention to the fellow who dressed me down for it.  For that fellow was Willem Buiter who, if you ask me (though admitting it only adds to my chagrin), is one of the best monetary economists around these days, and one whose writings deserve an even wider audience than the considerable one they already command.

As his unsparing (but mercifully brief) assault upon my article illustrates, Buiter doesn't go in for kid gloves, or for gloves of any sort: spotting what he believes to be a bad argument, he goes after it with bare knuckles, and more often than not lands a knockout punch.  Consider his trenchant critique of the fiscal theory of the price level.  Or have a look at his 2004 Hahn Lecture, in which he puts his dukes up against half-a-dozen "ghosts, eccentricities, mirages, and mythos" of contemporary monetary economics.  No, Sir: this is one monetary economist you don't want to mess around with.

Buiter is, on the other hand, a monetary economist whose work repays careful reading, and repays it at a decidedly positive real rate of interest.  I was reminded of this recently when, in the course of expanding upon my Congressional Testimony on Interest on Reserves, I came across a 2009 working paper by Buiter that I hadn't read before.  The question addressed by that paper — What obstacles stand in the way of central banks shrinking their swollen balance sheets and otherwise returning to conventional monetary policy? — makes it even more pertinent today than when it first appeared.  Yet because the paper was published as part of a somewhat obscure volume edited by the European Money and Finance Forum, it hasn't gotten much attention (Google scholar lists 13 citations, all to the working paper version).  That's a shame, for the paper is another good example of Buiter's ability to muster painstaking analysis in the service of blistering rhetoric, with devastating effect.

The gist of Buiter's argument is that, despite what monetary authorities in the U.S. and elsewhere may claim, "unwinding or reversing unconventional monetary policies," so as to reduce the relative size of central banks' balance sheets to pre-crisis levels, "is technically easy."  The real obstacles to such unwinding are, Buiter insists, political.  They consist, first, of a potential conflict between central bankers and fiscal authorities concerning "the role of seigniorage in closing the government's solvency gap," and, second, of the fact that any unwinding procedure "is likely to reveal the true extent of the central bank's quasi-fiscal activities during the crisis and its aftermath."

The conflict that constitutes the first of these obstacles arises because "the portfolio reshuffling that is the logical, unavoidable counterpart" to central banks' large-scale asset sales is likely to "create serious funding problems," especially for national treasuries.  In particular, to the extent that the sales reduce the central banks net interest income and financial surpluses, they must force associated governments to reduce their own deficits as well.  Unless such a program of deficit reduction is consistent with those treasuries own objectives, unwinding "could be delayed for years."

The extent of the delay will, of course, depend on central banks' ability to resist pressure from treasury authorities.  How great is that ability?  Not very, according to Buiter.  In the U.K., a Treasury unhappy with the Bank of England's aggressive pursuit of normalization might take control of monetary policy by invoking the Reserve Powers clause (section 19) of the 1998 Bank of England Act, allowing it to dictate policy provided that doing so is "required by the public interest and by extreme economic circumstances."  According to Buiter, its much-vaunted (if mostly mythical) independence notwithstanding, the Fed's constitution makes it even less immune to pressure from fiscal authorities than the Bank of England.

The second reason governments have for forestalling the unwinding of their central banks' unconventional policies — their desire to keep a cloak on those banks' quasi-fiscal activities — is so far as Buiter is concerned all the more reason for the general public to oppose any unnecessary delay:

The large-scale ex-ante and ex-post quasi-fiscal subsidies handed out by the Fed and to a lesser extent by the other leading central banks, and the sheer magnitude of the redistribution of wealth and income among private agents that the central banks have engaged in could (and in my view should) cause a political storm.

That the Fed and other central banks made the crisis an excuse for becoming quasi-fiscal agents in the first place was, in Buiter's opinion, inexcusable.  Like Bagehot (and Bernanke himself, to judge by the former Fed Chairman's utterances rather than his actions), Buiter believes that central banks have no business doing anything other than providing liquidity to illiquid but solvent financial institutions, "at a cost covering [their] opportunity cost of non-monetary financing":

Any action beyond that, such as the recapitalisation of insolvent banks through quasi-fiscal subsidies, ought to be funded by the Treasury.  The central bank should be involved only as an agent of the Treasury — an expert assistant.  It should not put its own conventional or comprehensive balance sheet at risk.

And why shouldn't a central bank take on quasi-fiscal functions?  Generally speaking, it shouldn't because doing so can impair its "ability to fulfill its macroeconomic stability mandate," and also because it may obscure responsibility and accountability "for what are in substance fiscal transfers."  In the U.S. case, Buiter notes, there is still another reason, and one that ought not to be dismissed lightly.  It is, simply, that the Fed's quasi-fiscal actions "subvert the Constitution, which clearly states in Section 8, Clause 1, that the power to tax and spend rests with the Congress."

That the Fed should have gotten away, not only with having allowed itself "to be used as an off-budget and off-balance-sheet special purpose vehicle for the Treasury," but also (until Bloomberg forced its hand after Buiter's article appeared) with refusing to divulge the details of its crisis-related fiscal transfers, seems almost incredible to the Dutch-born Buiter, who surrendered his Dutch citizenship in order to become a dual U.S.-U.K. citizen:

It is surprising that a country whose creation folklore attributes considerable significance to the principle of "no taxation without representation" would have condoned without much outcry such a blatant violation of the equally important principle of "no use of public funds without accountability."  This indeed amounts to a quiet coup by the central bank.

Would that more U.S.-born economists, including those who fell-over each other in their rush to defend the Fed against any prospect of routine GAO "audits," took the Constitution's plain language as seriously.

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EconTalk LIVE at Cato, ft. David Beckworth http://www.alt-m.org/2016/06/10/econtalk-live-at-cato-ft-david-beckworth/ http://www.alt-m.org/2016/06/10/econtalk-live-at-cato-ft-david-beckworth/#comments Fri, 10 Jun 2016 14:47:20 +0000 http://www.alt-m.org/?p=45423 Russ Roberts interviewed David Beckworth at the Cato Institute Thursday, May 19th, for a “recorded live” edition of his podcast series, EconTalk.  The final version of the podcast, along with video, was recently released.  Beckworth and Roberts mostly discussed the Fed and the Great Recession.  Towards the end of the conversation,...

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EconTalk LIVE 1Russ Roberts interviewed David Beckworth at the Cato Institute Thursday, May 19th, for a “recorded live” edition of his podcast series, EconTalk.  The final version of the podcast, along with video, was recently released.  Beckworth and Roberts mostly discussed the Fed and the Great Recession.  Towards the end of the conversation, Roberts also asked Beckworth about his support for a nominal GDP spending target.

Roberts began by asking Beckworth to tease out the difference between commonly heard explanations of the crisis and his own.  Most pundits analyzing the causes of the Great Recession zero-in on the housing sector.  They note the boom in housing prices, mortgage debt, and securitized financial bets.  The decline in housing prices thereby caused a panic that spread to the real economy.  Some blame government policy for the housing boom and bust, others a “financial sector run amok,” but either way the centrality of housing is rarely disputed.

Beckworth by contrast argues that housing only caused a mild downturn.  Blame for that downturn becoming a Great Recession rests with the Fed.  Beckworth points out that aside from the housing sector the economy grew from 2006 through the early part of 2008.  The fall in housing prices in early 2006 and beginnings of financial turmoil in early 2008 did not cause severe economy-wide trouble.  So what turned an isolated contraction into the Great Recession?  As Beckworth puts it “what’s the one asset held on every book? … [I]f you want to simultaneously mess up an entire economy, somehow affect the demand or supply for money.”

According to Beckworth, the Fed made three distinct mistakes: (1) it sterilized emergency lending, (2) held the fed funds rate target at 2.25% for an approximate five month period from April-October 2008, and (3) paid interest on reserves.

Beckworth discusses the Fed’s interest rate policy in the most detail, arguing that the Fed was far too concerned with potential inflation.  He points out that based on FOMC minutes and Ben Bernanke’s memoir the Fed was just as concerned with potential future inflation in September ’08 as it was with the real economy, and that as late as August ’08 Fed officials were still talking about the possibility of a rate hike.

Could cutting the overnight rate 2.25 points (between the Fed’s target and 0) have helped? Beckworth emphasizes that changes in the supply of money do not have a 1:1, consistent, effect on output.  But in the context of the weakened 2008 economy the failure to continue lowering rates was particularly painful.  Beckworth compares the heightened importance of monetary policy in 2008 to antibiotics.  When a patient has pneumonia, properly administering antibiotics is much more important than when a patient has no bacterial infection at all.

Beckworth also points to the Fed’s consideration of raising rates in summer ‘08 as support for his arguments on the significance of the Fed’s mistakes.  Futures contracts, notably, implied market expectations for the fed funds rate was as high as 3.25% in the summer of 2008, further illustrating the Fed’s target rate was well above the clearing or natural rate: the rate needed to keep output near its potential level.

“How might the Fed do a better job in future at keeping interest rates at the natural level?,” Roberts asks.  Beckworth responds that if the Fed targets nominal spending, rather than interest rates, it does not have to worry about knowing the natural rate.  Stabilizing spending, and then “letting the real side [of the economy] determine how that spending gets allocated” would ensure that interest rates move freely so that credit markets clear.  As part of a more general pitch for nominal spending targeting, Beckworth argues that this system would ensure a more “systematic, predictable, and rules based” Fed.  Beckworth mentions Scott Sumner’s proposal for the NGDP target to be set by a futures market.  According to Beckworth, such a proposal would allow for a completely automatic, non-discretionary monetary policy.

In the concluding moments, Roberts and Beckworth discuss the actual possibility for real change at the Fed.  While Beckworth makes the caveat that bureaucratic institutions like the Fed are rather adept at resisting change, he notes that there have been positive signs for supporters of NGDP targeting.  Notable economists Christina Romer and Michael Woodford have endorsed the idea, for example.  While a complete change in our monetary system might be far off, realistically, Beckworth envisions the possibility of raising his cane in triumph at a retirement home when that time comes.

Listen to the full podcast here, and or watch video, including a question and answer session not included in the official podcast here.

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Sound Money in Theory and Practice http://www.alt-m.org/2016/06/09/sound-money-in-theory-and-practice/ http://www.alt-m.org/2016/06/09/sound-money-in-theory-and-practice/#comments Thu, 09 Jun 2016 13:04:45 +0000 http://www.alt-m.org/?p=45085 In this commentary, I will analyze the concept of sound money and its relevance today.  The concept evolved in the 19th century as many countries adopted the gold standard.  It became associated with commodity money or “hard currency.”  For example, Mises (1966: 782) stated: The principle of soundness meant that...

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Bretton Woods. Gold standard, NGDP targeting, sound money

In this commentary, I will analyze the concept of sound money and its relevance today.  The concept evolved in the 19th century as many countries adopted the gold standard.  It became associated with commodity money or “hard currency.”  For example, Mises (1966: 782) stated:

The principle of soundness meant that the standard coins — i.e., those to which unlimited legal tender power was assigned by the laws — should be properly assayed and stamped bars of bullion coined in such a way as to make the detection of clipping, abrasion, and counterfeiting easy.  To the government’s stamp no function was attributed other than to certify the weight and fineness of the metal contained.

There was no requirement that “standard coins” be the exclusive or even preponderant means of payment in day-to-day transactions.  So long as banks of issue (private or central banks) maintained convertibility, then the monetary system had the characteristics of sound money.  As Mises suggested, government’s role was minimal.

As a matter of history, sound money is associated with commodity money.  Mises’ characterization assumes commodity money.  Can there be sound fiat currency?

Most 19th century writers on money assumed a system of commodity money with allowance for temporary suspensions during wartime and a return to the standard in peacetime.  The suspension of specie payments by the Bank of England during the Napoleonic Wars prompted banker Henry Thornton to author in 1802 a treatise on managing a paper currency: An Enquiry Into the Nature and Effects of the Paper Credit of Great Britain.  Thornton was a successful banker with an economist’s understanding of banking, finance, and the real economy.  He pioneered analytical distinctions that would not be rediscovered for almost another century: the distinction between real and nominal interest rates, and the concept of an equilibrium or natural rate of interest.

The volume should have become a standard reference work.  But it came to be forgotten because the Bank of England re-established convertibility, and other countries gradually adopted the gold standard over the course of the 19th century.  How to manage a fiat money system (paper credit) ceased to be a practical issue.

When the Federal Reserve System was created at the end of 1913, the United States was on the gold standard along with most of the rest of the world.  The Federal Reserve was not created to manage money in the modern sense, but to provide a national currency as part of a gold standard.  No one was thinking of managing a fiat currency on the eve of World War One.  That was all soon to change with the requirements of wartime finance.

After World War One, the world returned to a global, pseudo gold standard that was chronically short of gold reserves.  The currencies of many countries were overvalued relative to gold.  When the system collapsed in the 1930s, countries were thrust into a fiat currency world without a playbook.  For a time, there were efforts to restore the global gold standard but they came to naught.  World War Two interrupted any effort to craft a new international monetary system.

The post-War, Bretton Woods system constituted the new global monetary order.  Volumes have been written on it.  I do not share the nostalgia of some for it.  It was even less of a gold standard than existed in the interwar period.  In truth, it was a dollar standard.  The dollar was pegged to gold and other currencies pegged to the dollar.  There were numerous exchange-rate adjustments.  The system contained inner contradictions.  Inevitably, the producer of the dominant currency was bound to abuse its “exorbitant privilege” and the United States did so.  The system collapsed and the world was then on a fiat standard.

There was no accepted theory of managing money in a fiat money world.  This was not Henry Thornton’s world in which fiat money was a temporary expedient with an expectation of a return to specie conversion.  It was not the world of the classical quantity theory, which was constructed in a commodity-standard world.  The quantity theory demonstrated the limits of monetary expansion (or changes in the demand for money) before prices would begin to rise sufficiently to threaten convertibility.  In a classical gold standard, the supply of money is endogenous and the price level fixed in the long run.

Milton Friedman and the monetarists offered a restatement of the quantity theory and a model of monetary control for a fiat currency.  Friedman, his students and colleagues believed they had discovered stable empirical relationships among the monetary base, broader measures of money (especially M2), and the demand for money (Friedman 1956 and Friedman and Schwartz 1956).  When monetary targeting was finally implemented by the Volcker Federal Reserve in the 1980s, the posited empirical relationships broke down.  The Fed abandoned monetary targeting.

What followed was a period that John Taylor dubbed the Great Moderation, in which the Fed and other central banks seemed to get it right.  There was enhanced macroeconomic stability (as measured by decreased variance in prices and output).  Taylor discerned that the Fed was following a tacit rule, which others called the Taylor Rule.  But the Fed and then other central banks began to deviate from the rule by lowering interest rates in response to the Dotcom bust.  Taylor (2009) argued the housing bust was the consequence of the boom created by the policy of low interest rates.  “No boom, no bust.”  Central banks have not returned to a monetary rule.  Instead, they have engaged in monetary improvisation.

Money in the 21st century is proving immune to control by central bankers.  The relationship between monetary reserves and various monetary aggregates (the money multiplier) has broken down.  More precisely, central banks appear to have lost the ability to control inflation.  In the United States, Europe and Japan, inflation rates have remained chronically below central bank targets over the course of the economic recovery from the Great Recession.  (The growth of real GDP has also been subpar.)  Economists as diverse as Jerry Jordan (2016) and James Bullard (2016) have questioned whether our textbook models of money creation and inflation control are any longer valid.  That is not to say that future inflation rates will not rise to two percent or beyond.  If they do so, however, it will likely not be the consequence of any central bank policy actions (Jordan 2016).

To reiterate, I question whether we ever had a practical theory of how to manage money in a fiat money world.  The proponents of monetary rules believe they have such a theory. One class of such rules involves NGDP targeting.

The specific question I pose for advocates of NGDP targeting is how today will anything the Federal Reserve does to its balance sheet alter the growth rate of NGDP in a predictable fashion?  The answer to such a question could be that the central bank should do more.  How much more?  And what, then, becomes of the rule?  It sounds like a recipe for discretion.  In any case, central banks have been unable to get either component of NGDP to grow in a normal or predictable manner.

Monetary institutions and policies vary among the major central banks.  For instance, both the European Central Bank and the Bank of Japan have instituted negative interest rates on commercial bank deposits at the central bank.  Meanwhile, the Fed has been paying interest on bank reserves for some time.  The institutions and policies differ, are even opposed to each other, but the policy failures are common.  (The policies have failed on their own terms, regardless of whether one agrees with them.)

Let me return to the classical idea of sound money.  Sound money is a rule, but of a different kind than modern monetary rules such as the Taylor Rule or NGDP targeting.  Sound Money was not a rule based on empirical relationships among economic variables.  It was not invented, but discovered.  It is more analogous to the rule of law.  Mises (1971: 414) made this point clearly. “Ideologically it [sound money] belongs in the same class with political constitutions and bills of rights.  The demand for constitutional guarantees and bills of rights was a reaction against arbitrary rule and non-observance of old customs by kings.”

The argument for sound money is not merely a technical economic argument, but a political economy and even constitutional argument.  When classical economists contended that commodity standards were a bulwark against inflation, they did not suggest that there would be no variability of inflation under a gold standard.  Their own experience told them otherwise.  Rather, they recognized that a gold standard was protection against arbitrary actions by sovereigns to depreciate the currency.  Protection against arbitrary and capricious governmental actions is what constitutions are meant to provide.

Is there a way to avoid arbitrariness in monetary matters in a fiat money system?  Can a monetary rule of some type today provide the protections that existed in the classical, pre-World War One gold standard?  These questions are central to the debate over monetary rules.  They apart from the technical ones I raised above.  Both sets of questions need to be addressed in debates over monetary policy.

___________

References

Bullard, J. (2016) “Permazero.” Cato Journal. 36 (Spring/Summer): 415-29.

Friedman, M., ed. (1956) Studies in the Quantity Theory of Money. Chicago: The University of Chicago Press.

Friedman, M. and A. J. Schwartz (1963) A Monetary History of the United States, 1867-1960. Princeton: Princeton University Press.

Jordan, J. L. (2016) “The New Monetary Framework.” Cato Journal 36 (Spring/Summer): 367-83.

Mises, L. v. (1971 [1952]) The Theory of Money and Credit. Irvington-on-Hudson: The Foundation for Economic Education.

________ (1966) Human Action, 3d ed. Chicago: Henry Regnery.

Taylor, J. B. (2009) Getting Off Track. Stanford: The Hoover Institution Press.

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Two Ways of Viewing Capital and Real GDP Since 2000 http://www.alt-m.org/2016/06/07/two-ways-of-viewing-capital-and-real-gdp-since-2000/ http://www.alt-m.org/2016/06/07/two-ways-of-viewing-capital-and-real-gdp-since-2000/#comments Tue, 07 Jun 2016 13:21:37 +0000 http://www.alt-m.org/?p=44723 In the closing paragraph of my last entry I offered two hypotheses about the post-2008 US economy.  The first is that “real GDP has shifted to a lower path because of a shrinkage in the economy’s productive capital stock — a problem that better monetary policy (not feeding the boom)...

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housing bubble, market monetarism, capital stock, output gap, whiteIn the closing paragraph of my last entry I offered two hypotheses about the post-2008 US economy.  The first is that “real GDP has shifted to a lower path because of a shrinkage in the economy’s productive capital stock — a problem that better monetary policy (not feeding the boom) could have helped to avoid, but cannot now fix.”  It is reasonable to suppose that the capital stock has shrunk, I argued, because the housing boom diverted investible resources from more productive capital formation into housing construction.  The second is that potential output, as estimated by the Congressional Budget Office’s method, “is currently overestimated because capital wastage has not been fully recognized.”

Here again is the chart that frames the common account of our recent macroeconomic history, showing the paths of actual real GDP and of the CBO’s estimate of potential real GDP, this time in natural logs so that a constant growth rate corresponds to a straight line with constant slope:

White Image 1

This picture of the estimated “output gap” suggests no unsustainable boom in the US economy before 2007.  There was no bubble.  There was merely a return to full employment after the previous “dot-com” recession of 2001 pulled output below potential.  The Great Recession of 2007-09 then appears not as a reaction to an unsustainable path, but as a bolt from the blue, an exogenous shock. The initial drop in real GDP has to be explained by going off chart, e.g., by reference to the bursting of the housing bubble.  But the housing bubble is itself unexplained by macro data, not part of any general malinvestment-and-overconsumption boom.

Next, as Market Monetarists have emphasized, households responded to the start of the recession by hoarding money, reducing aggregate demand.  As I showed last time, there was indeed a jump in hoarding (as measured by the ratio of M2 balances to GDP) during 2009.  The Fed failed to increase the quantity of M2 in response, so aggregate demand did fall, which in a sticky-price world brought down real output.  (In 2009 the CPI and PCE price indexes also fell, but in this view not enough to clear the markets.)  This nominal shock helps to explain some part of the severity of the recession, but it can’t be the whole story.  It can’t explain why the economy has remained below its potential output level for more than six years.  It cannot explain why recovery to potential output has continued to fall short for so long.  That remains a puzzle.  The “output gap” has shrunk only because the potential output path has been revised downward, a revision explained by shrinking labor force participation.

The account of macroeconomic events that I prefer can be framed by taking the same path for actual real GDP, but instead contrasting it with a simple constant growth-rate path that extrapolates from the 2000-2003 trend, as follows:

White Image 5

This picture suggests that, between 2003 and 2008, real GDP rose unsustainably above its old trend.  The recession brought a return to reality, and then some.  Consistent with the view that the unsustainable boom was fueled by Federal Reserve credit expansion, here is the bulge in real M2 before and during the period:

White 4

Since 2009 the economy has followed a lower real GDP path, with no tendency to return to the old dashed path, let alone to the bubble path of potential output as estimated by the CBO.  To explain that, I suggest, we need to recognize a drop in the stock of productive capital goods due to the misallocation of investment to housing construction during the housing boom.

Consistent with capital shrinkage, the Bureau of Economic Analysis shows gross private domestic investment making a negative contribution to real GDP for nine consecutive quarters, 2007Q3 to 2009Q3 inclusive.  The CBO method of estimating potential output does not recognize any capital wastage during the period, however.  The CBO’s data website reports a continuously rising value for its capital services index, an input to its estimate of potential real GDP, during 2000-2014.  This is of course consistent with its continuously rising estimate for potential output.

White Image 4

I don’t know the literature on econometric estimation of the size of the capital stock well enough to criticize the CBO’s method in any detail, or to propose an alternative method that would give us a better way to estimate whether the path of capital accumulation has been shifted downward.  I would be grateful for pointers to any sites that use a method distinct from the CBO’s to provide explicitly derived estimates of the path of productive capital.

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Cato Journal: Revisiting Three Intellectual Pillars of Monetary Wisdom http://www.alt-m.org/2016/06/03/cato-journal-revisiting-three-intellectual-pillars-of-monetary-wisdom/ http://www.alt-m.org/2016/06/03/cato-journal-revisiting-three-intellectual-pillars-of-monetary-wisdom/#comments Fri, 03 Jun 2016 13:08:12 +0000 http://www.alt-m.org/?p=44313 A new issue of the Cato Journal, which collects the proceedings of last year’s Annual Monetary Conference, was released last week.  Those proceedings include a paper by Claudio Borio, head of the Bank for International Settlement's monetary and economic department, which Alt-M readers may find particularly interesting. According to Borio,...

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Claudio Borio, deflation, natural rate of interest, savings glut, secular stagnationA new issue of the Cato Journal, which collects the proceedings of last year’s Annual Monetary Conference, was released last week.  Those proceedings include a paper by Claudio Borio, head of the Bank for International Settlement's monetary and economic department, which Alt-M readers may find particularly interesting.

According to Borio, conventional thinking on monetary policy rests on three faulty assumptions:

First, that natural interest rates are those consistent with output at potential and low, stable inflation.

This assumption is important because monetary authorities are supposed to track natural interest rates when they set policy.  Unfortunately, says Borio, the mainstream view of natural interest rates is imprecise, since we know that dangerous financial build ups can occur even when growth is strong and inflation is on target.  Crucially, such build ups—excessive credit, inflated asset prices, and too much risk-taking — may be caused by interest rates that are too low.  Could it be that “natural” rates are themselves sometimes inconsistent with financial stability?  Borio thinks not, and suggests that we need instead to define natural rates more carefully, as rates “consistent with sustainable financial and macroeconomic stability.”  In practice, such a definition would lead monetary policymakers to “lean against” booms when times are good, and also to worry more about the long-term consequences of expansionary monetary policy (which Borio suggests may sow the seeds of future crises) during busts.

Second, that monetary policy is neutral over the medium- to long-term.

By contrast, Borio believes that monetary policy may in fact have significant long-term effects on the real economy.  It is hard to argue, for example, that low interest rates are not a factor in fueling financial booms and busts, given that monetary policy generally operates through its impact on credit expansion, asset prices, and risk-taking.  And when such booms and busts lead to financial crises, the effects can be very long-lasting, if not permanent: growth rates may recover, but output might never catch up with its pre-crisis, long-term trend.  Borio points out that financial busts weaken demand, since falling asset prices and over-indebtedness often combine to wreak havoc on balance sheets.  Financial booms, meanwhile, affect supply: BIS research suggests they “undermine productivity growth as they occur” by attracting resources towards lower productivity growth sectors.  Taken together, these points have important implications: on the one hand, monetary policymakers ought to be more careful about supporting booms; on the other, apart from resisting the temptation to encourage booms, there may not be much that monetary policy can do about busts, since “agents wish to deleverage” and “easy monetary policy cannot undo the resource misallocations.”

Third, that deflation is everywhere and always a bad thing.  

Not so, says Borio (and many here at Alt-M would agree with him).  In fact, BIS research has found that there is only a weak association between deflation and output.  When you control for falling asset prices, moreover, that association disappears altogether — even in the case of the Great Depression.  The key here is to distinguish between supply-driven deflations, which Borio suggests depress prices while also boosting output, and demand-driven deflations, which tend to be bad news all around.  By failing to draw this distinction, monetary authorities have introduced an easy-money bias into their policy decisions: in the boom years, when global disinflationary forces should have led to falling consumer prices, loose monetary policy instead kept inflation “on target”; then, in the bust years, central banks eased aggressively — and persistently — to stave off the mere possibility of a demand-driven deflation.  (Or did they?)

This leads neatly to the broader theory that Borio outlines in his Cato Journal article: that the long-term decline in real interest rates we have witnessed since the 1990s is not, as proponents of the “savings glut” and “secular stagnation” hypotheses suggest, an equilibrium phenomenon, driven by deep, exogenous forces; rather, it is a disequilibrium phenomenon driven by asymmetrical monetary policy, and may be inconsistent with lasting financial and macroeconomic stability.

In a nutshell, Borio believes that the three fundamental misconceptions outlined above have inclined central banks towards monetary policy that is expansionary when times are good, and then even more expansionary when times are bad.  Over the course of successive financial and business cycles, this skewed approach to monetary policy imparts a downward bias to interest rates and an upward bias to debt, which in turn leads to “a progressive loss of policy room for maneuver” as central banks cannot push interest rates any lower, but also cannot raise rates “owing to large debts and the distortions generated in the real economy.”  The result is entrenched instability and “chronic weakness in the global economy,” as well as what Borio calls an “insidious form of ‘time inconsistency,’” in which policy decisions that seem reasonable — even unavoidable — in the short term, nevertheless lead us ever-further astray as time goes by.  This will, undoubtedly, strike many readers as an apt description of the current state of play in monetary policy.

Here again is Borio’s complete article.  I encourage you to read the whole thing.  The entire monetary issue of the Cato Journal, titled “Rethinking Monetary Policy,” can be found here, and features articles from Stanford economist John Taylor, Richmond Fed president Jeffrey Lacker, and St. Louis Fed president James Bullard, as well as from Alt-M’s own George Selgin, Larry White, and Kevin Dowd, among others.  Happy reading!

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Misunderstanding the Net Interest Margin http://www.alt-m.org/2016/06/01/misunderstanding-the-net-interest-margin/ http://www.alt-m.org/2016/06/01/misunderstanding-the-net-interest-margin/#comments Wed, 01 Jun 2016 13:07:49 +0000 http://www.alt-m.org/?p=43947 Lately, there have been a lot of discussions in the media and in the academic sphere surrounding banks’ net interest margin in the low (or negative) interest rate environment.  I have explained before how lowering interest rates below a certain threshold led to "margin compression" (see here), which in turned depressed...

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interest on reserves, margin compression, negative interest rates, net interest margin, risk adjustmentLately, there have been a lot of discussions in the media and in the academic sphere surrounding banks’ net interest margin in the low (or negative) interest rate environment.  I have explained before how lowering interest rates below a certain threshold led to "margin compression" (see here), which in turned depressed banks’ profitability and hence their internal capital generation, solidity and ability to lend.

The net interest margin (NIM thereafter) is roughly the difference between the average interest rate earned on assets and the average interest rate paid on funding, and is usually defined as:

Net interest income / average earning assets, with NII being the difference between interest income (from loans and securities mostly) and interest expense (on deposits and other types of debt/funding instruments)

We now see conflicting articles and research pieces on the effects of low rates on banks’ NIM (see two of the most recent ones by the St Louis Fed here and other Fed researchers here).  But, to my knowledge, most, if not all of those pieces make the same fundamental mistake: they do not look at risk-adjusted NIMs.

"Risk adjustment" is a critical concept but sadly often overlooked in the literature.  I once defined the interest rate on a loan as the following:

LR = RFR + IP + CRP – C,

where LR is the loan rate, RFR is the applicable, same maturity, risk-free rate, IP the expected inflation premium, CRP the credit risk premium that applies to that particular customer and C the protection provided by the collateral (which can be zero).

As I explained elsewhere, margin compression occurs when the risk-free rate declines so much that interest rates banks pay on their funding reaches the zero lower bound while their interest income continues to decline (which led me to hypothesise that the zero-lower bound was actually a "2%-lower bound" in the case of the banking/credit channel of monetary policy).  This however assumes no fundamental change in the rest of the economy’s credit (or default) risk.

Indeed, in bad economic times, the CRP usually increases for most borrowers, partially offsetting the effects of the decline in the risk-free rate on new lending.  Moreover, bankers can easily boost their NIM by lending relatively more to higher-risk customers or investing in higher-risk projects, even in good economic times.  Consequently, it looks like the headline NIM isn’t suffering or declining that much.  It can sometimes even improve, in particular when economic conditions are benign. For instance, emerging market banks often boast high NIMs, but also high default rates (and high ‘losses given default’).  In such cases, margin compression seems not to be occurring. But this is just an accounting illusion.

See the example in the chart below, which represents the hypothetical evolution of the different components of a given unsecured loan rate throughout a long recession:

NIM components

Once you adjust the NIM for the loan book’s underlying risk, the story is different.  Banks’ interest income can rise but the risk of default on new lending, as well as that of their legacy loan portfolio, also rises.  Because the CRP is often fixed at inception, legacy lending now underpays relative to its risk profile, potentially implying economic losses down the line.

Most studies don’t factor this phenomenon in.  They look at unadjusted NIMs, which in many cases do not provide any useful information.

A very good and quite recent paper on banking mechanics by Claudio Borio and his team (The influence of monetary policy on bank profitability), which looks at the impact of the shape of the yield curve on margin compression and banks’ profitability, does understand that accounting plays a significant role:

The second form [of dynamic effects in the transmission of the level of interest rates to net interest income], which is more relevant, relates to accounting practices.  Any interest margin on new loans also covers expected losses.  But provisions in the period we examine follow the “incurred loss model”, so that, in contrast to interest rates, they are not forward-looking.  As a result, extending new loans raises profitability temporarily, since losses normally materialise only a few years later at which point loans also become non-performing, eroding the interest margin.  This also  means  that  if  lower  market  rates  induce  more  lending,  they  will  temporarily boost net interest margins.  The strength of this effect will depend on background economic conditions.  For instance, it is likely to be weak precisely when interest rates are unusually low and the demand for loans anaemic.

However, they stop short of providing a solution, or a correction, to this effect.  To be fair, risk-adjusted NIMs are not directly observable and very difficult to estimate, given that disclosures about banks’ loan portfolio are very limited and that only some of their customers (i.e. large corporates) have bonds or credit default swaps traded on the secondary market.  Therefore, some analysts use the following ex-post adjusted NIM ratio:

(Net interest income – loan impairment charges) / average earning assets

Default risk, expressed in the income statement by loan impairment charges (LICs — also called loan-loss provisions), is directly deducted from net interest income, making the NIM easier to compare across banks or countries.  But even this version can be highly inaccurate, as LICs are backward-looking and depend on each bank’s accounting policies.  In the short-run, some banks tend to over-provision, others to under-provision.

You’ve reached the end of this post perhaps wondering whether I had a solution to this problem. Unfortunately no, I don’t.  But I believed that a clarification was in order.  In finance, or economics in general, any decision involves risk-taking, and studies that do not take risk into account must be taken with a pinch of salt.

PS: The inflation premium is stripped out of the risk-free rate in this post, but in practice benchmark market rates such as Treasuries already factor in inflation expectations.

[This article originally appeared on Spontaneous Finance]

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