Monetary Musings

Here are some monetary musings:

(1) In case you still happen to believe the Fed's actions in the early-to-mid 2000s were largely inconsequential and that its monetary policy stance was appropriate then you need to read this article by Barry Ritholtz. He does a great job showing that many of the credit market distortions and misused financial innovations would not not have occurred had interest rates not been pushed so low by the Fed. Ritholtz's article complements the academic literature on the "risk-taking" channel of monetary policy.

(2) Richard Alford, a former NY Fed economist, reviews the Fed's actions leading up to and during this crisis over at Naked Capitalism. He finds much wrong with Fed policies during this time but cautions us to be careful in how we criticize the Fed:

Criticize the Fed for failing to deliver financial and economic stability. Criticize the Fed for failing to discharge its responsibilities as a regulator. Criticize the Fed for foolishly exceeding its mandate. Criticize the Fed for assuming responsibilities for which it was not designed and ill-prepared. Criticize the Fed for permitting itself to be turned into an off balance sheet Treasury Department SIV. Criticize the Fed for charging in to a political mine field. The Fed deserves it.

Limit criticism of the Fed for not being what it was never designed to be: a means to unwind/resolve financially troubled, systemically important firms. Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).

Criticize the Fed for its role in AIG, but keep it in perspective. Whatever the costs to society and the taxpayer of the mistakes the Fed may have made in the AIG fiasco, they are small change compared to the cost of the Fed’s inappropriate monetary policy, the Fed’s ignoring its regulatory responsibilities, etc. In addition, compare the cost to society of any Fed errors at AIG with the costs of Treasury and Congressional inaction and/or their hasty decisions if the Fed had not assumed control of AIG

(3) Josh Hendrickson is thinking about monetary policy using the expanded equation of exchange, an approach I have used before. Here is Josh:

[C]onsider a simple monetary equilibrium framework captured by the equation of exchange:

mBV = Py

where m is the money multiplier, B is the monetary base, V is the velocity of the monetary aggregate, P is the price level and y is real output. The monetary base, B, is the tool of monetary policy because it is under more or less direct control by the Federal Reserve. The Fed’s job is to adjust to base in order to achieve a particular policy goal.

Other important factors in the equation of exchange are the money multiplier, m, and the velocity of circulation, V. These are important because V will reflect changes in the demand for the monetary aggregate whereas m will reflect changes in the demand for the components of the monetary base.

Now suppose that the Federal Reserve’s goal is to maintain monetary equilibrium. In other words, the Fed wants to ensure that the supply of money is equal to the corresponding demand for money. In the language of the equation of exchange, this would require that mBV is constant. Or, in other words, that changes in m and V are offset by changes in B.

This goal would certainly make sense because an excess supply of money ultimately leads to higher inflation whereas an excess demand for money results in — initially — a reduction in output. Unfortunately, this is a difficult task because it is difficult to observe shifts in m and V in real time. Nonetheless, there is an alternative way to ensure that monetary equilibrium is maintained. For example, in the equation of exchange, a constant mBV implies a constant Py. Thus, if the central bank wants to maintain monetary equilibrium, they can establish the path of nominal income as their policy goal.

I wish textbooks included discussions like this.

Forget Greece, Germany Should Leave the Euro...

So says Joachim Starbatty in the NY Times:

The Greek crisis is only the first of what could be several tremors resulting from the euro’s original sin. While few are willing to say it yet, the solution is clear: the only way to avoid further harm to the global economy is for Germany to lead its fellow stable states out of the euro and into a new and stronger currency bloc.

[...]

If Germany were to take that opportunity and pull out of the euro, it wouldn’t be alone. The same calculus would probably lure Austria, Finland and the Netherlands — and perhaps France — to leave behind the high-debt states and join Germany in a new, stable bloc, perhaps even with a new common currency. This would be less painful than it might seem: the euro zone is already divided between these two groups, and the illusion that they are unified has caused untold economic complications.

A strong-currency bloc could fulfill the euro’s original purpose. Without having to worry about laggard states, the bloc would be able to follow a reliable and consistent monetary policy that would force the member governments to gradually reduce their national debt. The entire European economy would prosper. And the United States would gain an ally in any future reorganization of the world currency system and the global economy.

Does this make any sense?

And I Thought New Zealanders Were Tough on Their Central Bankers

From NPR we learn the North Koreans show no mercy to central bankers:

If media reports in South Korea are accurate, earlier this month, North Korea hauled its equivalent of Alan Greenspan[,Pak Nam Gi,] in front of a firing squad.

[...]

Many analysts believe Pak was made a scapegoat for the currency reform.

So what went wrong? It seems that the currency "reform" was more of a currency debasing:

The currency reforms were meant to confiscate merchants' wealth and give it to farmers, workers and soldiers in the state sector. Many state-owned firms have fallen idle, and their workers have gradually migrated to the free markets to survive.

The plan worked, at least for a while, says Kim Yun-tae, secretary general of the Network for North Korean Democracy and Human Rights, a Seoul-based group that gets information from a network of informants in North Korea.

"The government printed money and distributed it to farmers and the lower classes," Kim says. "People loved it at first. But when the working class spent all that money, it was eaten up by inflation, and their lives got even harder."

Another needless tragedy for North Korea and another needless disruption to the welfare of North Koreans.

Another Nail in the Global Saving Glut Coffin

David Laibson and Johanna Mollerstrom have a new paper--see here for a shorter version--that further undermines the popular global saving glut theory (GSG). According to the GSG theory there was an increase in global savings beginning in the mid-to-late 1990s that originated in Asia and to a lesser extent in the oil-exporting countries. This surge in global savings found its way into the United States via large current account deficits that, in turn, created the asset bubbles of the past decade. Laibson and Mollerstrom argue the GSG theory has the causality backwards: the asset bubbles in the advanced economies came first and spurred consumers to go on a consumption binge. That consumption binge, in turn, was financed by savings from abroad. The smoking gun in their story is that had the foreign funding been truly exogenous then there would have been a far larger investment boom given the amount of foreign lending. Instead, there was a consumption boom which is more consistent with causality starting from an asset bubble. Their paper adds to their growing chorus of SGT skeptics including Menzie Chinn, Maurice Obstfeldt andKenneth Rogoff, Guillermo Calvo, and myself.

Interestingly, Laibson and Mollerstrom note that their story fails to answer two important issues:

There are many open questions that we have failed to address, but two stand out in our minds. First, our model takes the existence of the asset bubbles as given and does not explain their origins.

[...]

Second, our model does not explain why global interest rates fell between 2000 and 2003, and thereafter stayed at a relatively low level.

Well let me help Laibson and Mollertrom here. The actions of U.S. monetary policy can answer the first question and at least the first part of the second question for this period. As I have written before, this is easy to see given the Fed's monetary superpower status:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

In short, the Fed set global monetary conditions at the time and pushed global short-term rates below their neutral level which, in turn, started the asset booms. Of course, financial innovations and credit abuses also played a role and may explain the persistence of the low global interest rates. I think my monetary superpower hypothesis fits nicely with the Laibson and Mollertrom story. One more nail in the saving glut coffin.

P.S. In case you are wondering, here is evidence the Fed kept the federal funds rate below the neutral rate during the early-to-mid 2000s (source). Here is more formal evidence from the ECB.

Recommended Readings

• A Lucas Critique of Monetary Policy as Interest Rates--Nick Rowe
• Credit Boom 2003?--Bill Woolsey
• That “Ungainly” NGDP--Scott Sumner
• How Exorbitant is the Dollar’s “Exorbitant Privilege”?--Maurizio Habib
• The Baseball Card Bubble--Dave Jamieson
• Greece Rescue = Smoke and Mirrors--Yves Smith
• The Low Down on Interest Rates--Ryan Avent

More Support Across the Atlantic

Samuel Brittan is not the only one in the UK who thinks stabilizing total nominal spending should be the objective of monetary policy. Giles Wilke, the chief economist of Centre Forum and author of the blog Freethinking Economist, has come out with a paper that says the Bank of England's quantitative easing program needs to be adjusted to something like a nominal GDP target:

The Bank should explicitly target nominal growth for the duration of the slump. The current narrow focus on inflation leaves the markets expecting the withdrawal of QE before it has become effective. Such expectations badly undermine the policy. An explicit announcement of a high nominal growth target will help convince the economy that liquidity will remain available for long enough to reassure (and therefore encourage) investors.

This paper actually was the inspiration for Samuel Brittan's column in the Financial Times. It also shows how individuals from different sides of the political spectrum can agree on this issue. Also making the case for a nominal GDP target and hailing from the UK is Edmond Conway, economics editor of the Telegraph newspaper. He too was inspired by Wilke's paper and now wants the Bank of England to scrap its inflation target and move to a nominal GDP target. Wilke's paper, then, appears to be influencing the debate in the UK. This is good news.

"Deposit Insurance" for the Shadow Banking System

Here are some more thoughts inspired by Gary Gorton's work and discussions at the Economics Blogger Forum. During the Great Depression of the 1930s there were runs on the banking system. These panics were based on depositors rushing to get their money back from the banks. The federal government response was to create deposit insurance. This response worked but it also created moral hazard problems that, in turn, required more government regulation.

During the Great Recession of the late 2000s something similar happened. There was a run on the shadow banking system in the repurchase agreement (repo) market by institutional investors and nonfinancial firms. Repos represent a liability for the shadow banking system just as deposits do for the traditional banking system. According to Gorton, the repo market is around $12 trillion in size (compared to about $10 trillion in assets for the traditional U.S. banking system) so this was a major bank run. Like deposit holders during the Great Depression, repo holders in this crisis wanted their money back and could get it by (1) forcing the shadow banks to take a haircut on the collateral used in repos or (2) not renewing the repos . As a result, repo markets began freezing up and threatened the shadow banking system. Since the shadow banking system is a conduit for funding the traditional banking system, financial intermediation in general became threatened (See Gorton for more details). The official response to this banking panic was for the Federal Reserve to create liquidity programs to effectively unthaw the repo market. Like deposit insurance in the 1930s, this government intervention stopped the run on the shadow banking system. Now that these liquidity facilities have been tested and shown to work, there is an expectation they will be used again if needed. And like the deposit insurance for the traditional banking system, this modern form of "deposit insurance" for the shadow banking system is bound to create moral hazard problems that will ultimately lead to more government regulation. These are interesting parallels.

The emergence of the shadow banking system, therefore, not only has implications for the correct measure of the money supply, but also for what will be the new moral hazard and government regulation of the financial system.