The Winter 2019 edition of the Cato Journal, the Cato Institute’s interdisciplinary journal of public policy, is now available online! In this latest issue, CJ editor and Cato’s vice president for monetary studies James A. Dorn includes six articles and one book review on topics related to financial regulation and monetary policy. Here’s a brief rundown with links to the full-text articles.
The lead article in this edition of the Cato Journal is based on SEC Commissioner Hester Peirce’s keynote address at the Cato Institute Summit on Financial Regulation, held in San Francisco in September 2018. (A full summary of that event is available here, with video of Peirce’s speech available here.) Both the speech and the article liken the role of a regulator to that of a parent and encourage “free range” over “helicopter” regulating — with Peirce urging regulators to allow for greater risk-taking, which she argues is a vital element of financial market. Peirce’s attitude, which was also at the root of her critical dissent of the SEC’s decision to the deny the Winklevoss twins’ application for a Bitcoin ETF, has earned her the nickname “Crypto Mom” on Twitter.
Peirce also reflects on five lessons she has learned from dealing with the rapid development of cryptocurrencies. First, regulators should respond to attempts to bring innovative solutions into financial markets with an appropriate degree of humility. Second, efforts to protect investors from the risks of innovative financial technologies are not like likely to quell their desire for those technologies. Third, providing innovators with greater clarity and certainty in their interactions with the SEC is essential to encouraging innovation. Fourth, the SEC's investor protection role needs to incorporate a commitment to expanding investor access to financial markets. And, fifth, regulators play a role in determining just how revolutionary technological innovations become in our financial markets and should be innovative themselves to adjust.
This article is a lightly edited version of former Richmond Federal Reserve president Jeffrey M. Lacker’s H. Parker Willis Lecture at the Washington and Lee University. Lacker discusses Willis's legacy and his impact on the history of the Federal Reserve, while simultaneously arguing that the Fed’s lending authority has since become “more of a hindrance than a help.”
Lacker begins by describing the circumstances surrounding the U.S. Federal Reserve’s founding in December 1913. At that time, the economy suffered from the fundamental problem of an inelastic supply of currency, which had contributed to a series of bank panics that plagued the economy. To solve this problem, Willis and others designed the Federal Reserve Act, which would establish a series of regional Reserve Banks with authority to lend directly to commercial banks as a means of conducting monetary policy.
The article goes on to explain how the “reals bills doctrine” — which had a major influence on Willis and was a central tenet of the early Federal Reserve System's operations — contributed to the Great Depression, as well as how Fed lending and conduct of monetary policy evolved after that doctrine was abandoned. Over time, Lacker argues, Fed lending has become “divorced from monetary policy and untethered from the Fed’s fundamental mission.” Moreover, the Fed’s lending has gradually fostered “fragile financial arrangements.” Lacker closes by outlining his views on how to improve financial institutions’ incentives, which may ultimately include repealing the Fed’s remaining emergency lending powers and restricting the Fed’s conduct of monetary policy to a portfolio consisting only of Treasuries.
Sebastian Edwards, the Henry Ford II Distinguished Professor of International Economics at UCLA, analyzes two cases of contract conversions during currency policy shifts — the United States’ abandonment of the gold standard in 1933, and Argentina’s devaluation of the peso in 2002. Studying those cases provides clues on the “likely consequences of decisions to ditch a monetary regime that constrains discretionary monetary policy, replacing it by one that allows, at least in principle, for the emergence of some form of fiscal dominance.”
Such fiscal dominance — i.e. when monetary policy and central banks’ conduct are neither independent nor discretionary but are instead dominated by fiscal policy at the behest of the state — has resulted in hyperinflations in countries like Peru, Venezuela, and Argentina. Yet, it also enables countries to make their exports more competitive in hard economic times via devaluation.
As Edwards points out, however, countries that are dollarized, have a currency board, or are in a monetary union like the Eurozone, are not able to practice fiscal dominance unless they exit their current monetary regime and reintroduce a domestic currency. By examining in detail the cases of the United States and Argentina, Edwards demonstrates that in both instances, “conversion of massive contracts from one currency to another was cumbersome, logistically difficult, legally problematic, and, at the end of the road, costly for society.” Thus, this oft-overlooked reality of abandoning an existing regime — for example, if Italy or Greece would leave the eurozone or if Ecuador discarded dollarization — should not be ignored.
Peter Ireland, the Murray and Monti Professor of Economics at Boston College, comments on Fed Chair Jerome Powell’s August 2018 Jackson Hole speech on the state of the economy, while making the case for rules-based monetary policy.
Ireland compares the economic outlook outlined by Powell, based on the traditional Phillips Curve framework, with a nominal GDP growth-based forecast, which according to Ireland “provides another useful index of the effects that monetary policy is having on the economy.” NGDP growth — the sum of real GDP growth and nominal price inflation — captures, “in a single number, the Fed’s performance in satisfying both sides of its dual mandate for maximum sustainable growth with stable prices,” without depending on the increasingly unreliable Phillips Curve relationship between unemployment and inflation.
The author then turns to the relationship between the natural rate of interest and monetary policy implementation and lays out the Federal Reserve’s policy challenges going forward. He suggests that switching to a rules-based monetary policy would enable the Fed to communicate their actions more transparently, and to deal more effectively with the what Chairman Powell presented as the risk and uncertainties of the global economy.
In this article, Yiping Huang, Professor of Economics and Deputy Dean of the National School of Development and Director of the Institute of Digital Finance at Peking University, and Tingting Ge, a PhD scholar at the National School of Development at Peking University, evaluate the present impact and future of Chinese financial reform and development.
First, Huang and Ge describe China’s process of prior financial reforms, summarizing its distinctive features and the logic behind it. The authors then assess the impact of the policies, distinguishing whether they had a negative “McKinnon effect,” hindering financial efficiency and development, or a positive “Stiglitz effect,” helping effectively convert saving into investment and supporting financial stability. They conclude that financial repression in China — which enabled the growth of financial institutions and financial assets but constrained free market mechanisms for resource allocation — had positive effects on economic growth and financial stability during the country’s earlier stages of development. More recently, however, China’s repressive financial policies have begun to hurt its economic and financial performance as the country has entered the later stages of economic development and come to “rely more on innovation and industrial upgrading instead of mobilization of more inputs.”
Finally, Huang and Ge discuss how their findings on the relationship between financial repression and economic development might guide China’s and other countries’ fiscal policies going forward. They recommend the Chinese government “push ahead with further financial reforms, especially increasing the role of the market and opening the financial sector to the outside world.”
Andrew Liu, a senior at Dartmouth College, writes about the People’s Bank of China’s June 2018 payments regulation, which requires all mobile payments be cleared through the PBOC and, by extension, the Chinese Communist Party.
Liu begins with a survey of China’s past and present mobile payments landscape: in 2016, $9 trillion worth of mobile payments were made in China, compared to $112 billion worth in the United States. After reviewing China’s history of regulating mobile payments and examining the effects of its most recent law, Liu questions the necessity of the PBOC’s move given their stated motives: making mobile payments more secure and curbing criminal activity.
Ultimately, Liu finds that this new regulation will not improve mobile payment security, rather it will compromise “the incentives of mobile payment providers and funnel mobile payment transactions into more illicit and unsecure channels.” Moreover, he warns that the “new regulation provides the government with unprecedented access to data detailing the lives of its citizens and will assist it in taking down political opponents, extracting additional rents, and closely monitoring its citizens and implementing its social credit system.”
Book Review: A Crisis of Beliefs: Investor Psychology and Financial Fragility by Nicola Gennaioli and Andrei Shleifer
CMFA policy analyst Diego Zuluaga reviews A Crisis of Beliefs: Investor Psychology and Financial Fragility by Nicola Gennaioli and Andrei Shleifer. Published in August 2018, the book follows an already sizable canon of literature about “periodic bouts of 'irrationality in security markets.'” In particular, the authors focus on the concept of diagnostic expectations — the idea that investors fail to incorporate all available information and rely excessively on news stories when making decisions, which distorts their likelihood of accurately predicting future outcomes. Thus, investors become overly enthusiastic in good times, and overly pessimistic in bad.
According to Zuluaga, the authors offer “a rigorous theory of financial crises and credit bubbles grounded in the findings of behavioral psychology,” but fall short in applying their model of diagnostic expectation to any events other than the 2008 financial crisis, which they posit can be explained by their model. In the end, per Zuluaga, “the reader is left hoping for a theoretical breakthrough” that will provide an answer as to whether so-called irrational exuberance can be “diagnosed, quantified, and acted upon.” Such an answer never comes in A Crisis of Beliefs, but the book “opens new vistas for finance researchers” — and “holds out the hope that we can learn something from the despondency and euphoria that intermittently grip financial markets.”