Matt Nolan

Seperating shocks on financial intermediation

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Goldman Sachs has raised an interesting issue regarding the future of financial intermediation following the crisis:

New bank regulations and capital requirements are “structural” changes to the industry that are more to blame for declining profits than the U.S. economic slump, Goldman Sachs Group Inc. (GS) analysts said.

Remember, we have had the failure of Lehman Brothers (the Global Financial Crisis), the sovereign debt issues in Europe (the European debt crisis), and in the NZ context the failure of the non-bank financial sector post-05.  These crises can be expected to have a relatively persistent impact on economic activity – but not permanent.  Once all is said and done, and financial stability is returned, economic activity should in turn recover.

However, if the “wedge” (inefficiency) in financial markets persists indefinitely this suggest that something else is the cause.  Let’s also remember that at the same time that all this was going on financial regulation by central banks around the world has also changed!  While these changes will increase the stability of the financial system – they come with a permanent cost in terms of economic efficiency … there could potentially be a persistent wedge between the return to lenders and the cost to borrowers due to these policies.

Given both happened at the same time we can’t “identify” what did what – which makes the outlook even more unclear than it usually is.  However, it is important to keep all these disparate causes in mind when trying to understand what is going on.

Matt Nolan

Big news from Europe

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It should not be understated how important this would be for the world, and more importantly for New Zealand 😉

The suggestion that there is now a clear consensus for a plan that will essentially make the ECB a lender of last resort for the European financial system will help to knock the “financial crisis” element of what is going at the moment on its head.

If the ECB commits to limiting bond yields on government debt in the Eurozone, and backs that commitment with a statment saying it will do “unlimited purchases of bonds” we will finally have a conclusion to the bitter uncertainty that the European debt crisis has created for the world more generally.  As a result, Europe will continue to struggle, but the rest of the world can move forward.

Another thing that will become clear is the nature of the crisis – are peripheral governments facing a crisis of liquidity, or are they insolvent?  If it is liquidity, the ECB’s commitment will be enough to solve the problem – they won’t even need to actually buy many bonds!  If these countries are insolvent then the ECB is taking on a bunch of bad debt – a cost that will have to be faced by someone eventually.

If the ECB does come out full hog, we are going to see a significant improvement in the outlook for the global and New Zealand economies – albeit from the current incredibly negative outlook that most people currently have.

Matt Nolan

Will current expansionary policy lead to “bubbles”

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An excellent post over at Marginal Revolution on this.  The points raised are:

1. If a more expansionary monetary policy helps an economy recover, yes it may well raise the risk of a later bubble.  We should then be cautious, but that is no reason to turn down the prospect of a recovery.  Anything leading to recovery could have a similar risk.

2. There are already plenty of reserves in the system and there is plenty of room for credit to expand over its current level.  Maybe we don’t know what triggers bubble-inducing investment behavior, but why should raising ngdp expectations and realities raise the risk of a bubble, if not for the factor cited in #1?

3. Arguably a flat yield curve induces a quest for higher returns elsewhere or in more dubious investment areas.  Yet the flattening yield curve did not follow quickly from the massive injection of reserves.  Rather it evolved slowly as prospects for real recovery deteriorated and the long-run outlook for the advanced economies turned down.  Real factors drove the flattening, and if monetary expansion brought a bit of recovery it likely would unflatten that curve a bit.  That could well lower the risk of a bubble.

4. I may consider Austrian theory, with regard to this question, in a separate post.

There are two points I would raise here though.

With regards to bullet three – although I agree that the flat yield cuve is likely the result of weak prosepects for the economy, we can’t really pretend that the long end of the yield curve is currently independent of relatively direct government involvement.  The Fed’s willingness to buy up longer term Treasury bonds in order to stimulate growth could indicate that the low yield curve is partially the result of intervention, rather than true expectations of long term inflation and growth propsects.

Interestingly, I agree with bullet point three – I think that if there were sufficient asset purchases we would actually see the yield curve steepen (through its impact on expectations).  But this is clear, or necessarily the mainstream, view of what is going on.

The second point is that bubbles aren’t necessarily bad – in any sense of the word.  They transfer resources between groups, groups who chose to take risk.  They lead to a change in the timing of investment, often in a way that is suboptimal – but not disasterous.  A “bubble” in of itself doesn’t lead to a failure of monetary policy, and it doesn’t lead to a large scale downturn – there are other significant factors that have lead to these things internationally, factors that were correlated with the bubble (maybe even related to it) but not caused by it!

Matt Nolan

Justifying macroprudential policy

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Here is a good post on VoxEU, that aim to give a strong conceptual framework for justifying macroprudential policies:

The purpose of macroprudential policy is to reduce ‘systemic risk’ …

It is common to distinguish two key aspects of systemic risk. One is the “time-series dimension”: the procyclicality of the financial system, that manifests in excess risk-taking in booms and excess deleveraging in busts. Another is the ‘cross-sectional dimension’: the risk of contagion due to simultaneous weakness or failure of financial institutions. Accordingly, macroprudential policy it thought of as a set of tools that help reduce these two forms of risk (Borio 2009; Bank of England 2011).

Yet thinking about macroprudential policy by looking solely at these two dimensions of risk is unsatisfactory. First, this view, per se, does not provide a justification for regulatory intervention. For example, is it really desirable to avoid any form of cyclicality and have a zero risk of contagion in the financial system? Second, it is not a priori clear what can macroprudential policy achieve that traditional micro-prudential regulation cannot.

In a recent IMF study (DeNicolò et al. 2012), we aim to tackle these questions. We start by articulating that, as for any form of regulatory intervention, the objective of macroprudential regulation must be to address market failures.

Following the crisis we have heard many commentators demand something should be done.  Those with more of an economics bent could see the value of macroprudential policies, however regulation shouldn’t be based solely on the intuitive feel of economists and analysts – instead we should use the descriptive economic framework to help us understand what issues may exist in the financial industry, and then ask whether policy can help to improve outcomes.

Whether the externalities they have identified are fair is another question, one day I will read the paper and have a think – although I probably won’t post on this.  However, actually looking at regulation through a regulatory framework instead of screaming about large movements in arbitrary aggregates is the appropriate way to think about direct regulation in the financial industry (along with a recognition that we provide these firms implicit insurance) – a point of view that has been missing from some writing about the introduction of any such measures.

Matt Nolan

New data series: Monthly comparative price levels

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In my constant hunt for new data sources, I made my way to the OECD data portal – a great resource.  I wanted to check up on some PPP’s for a project I’m doing and I noticed a new series sitting around called “monthly comparative price levels”.

It allows you to compare how much you have to spend in your own currency to buy a certain amount of goods in another country – effectively for a New Zealander it shows how much you would spend in NZ$ to buy a bundle of goods in another country, where this bundle of goods cost $100NZ in New Zealand.

The series only appears to have shown up on March 8, and there is a single month – January 2012.  However, as this series builds up it is going to be very interesting.  Even the data for the single month was very very interesting.

For example, it currently takes $100NZ to buy $100NZ worth of stuff in the United Kingdom … so relative price levels in NZ and the UK are bang in line.  Not a result I expected at all.

It also shows that things are all very expensive in Aussie, and very cheap in the USA – very much in line with current thinking.

The PPP’s used in this series are consumption PPPs (rather than GDP PPPs), which means that these relative price levels are very much set up to help us compare consumption bundles (in the same way that growth in CPI is meant to allow us to understand growth in the underlying price of consumer goods).

No-one else may care, but I figured I’d note this down here so I can remember to come back to it later 😉

Matt Nolan

The bad side of independence?

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For me, the independence of central banks is one of the greatest institutional changes that has taken place in the past 30 years when it comes to “economic management”.  This independence has allowed central banks to clearly articulate goals and ensure that the arbitrary monetary distortions that previously occurred no longer take place – governments can not use storage, and central banks are generally less likely to accidentally tighten or loosen conditions inappropriately.

But this independence, and this view that a central bank provides some central “management” role has led an increasing number of writers to believe that the central bank truly controls the economy.  Not just in a broad sense, but there is a belief that a central bank can meet many disparity micro goals, changing the structure of the economy, controlling firms pay structures, changing inequality.

There was a time not so long ago when it was clearly recognised that STRUCTURAL issues were the responsibility of Treasury – if there was a clear defined market/institutional/government failure to deal with.

But now an increasing number of these broad structural issues are being blamed on central banks, there is an increasing belief that by changing an interest rate the Bank can separately determine a myriad of clear “good and bad” potential outcomes – and people appear to get frustrated because they feel that central banks are purposefully making things worse.

But this is not true, monetary policy is inherently cyclical, financial stability issues are just that … issues of financial stability.  If there are failures in the more general economy it is due to either the imperfection of the world we live in or the inappropriateness of government policy settings (in either direction) – it is not due to the central bank setting the wrong interest rate, or making the wrong comment in their latest statement.

I just hope this fundamental lesson will be remembered before people decide to start diluting the independence of, or stretching the role of, our central banks.

Update:  This issue is discussed more sensibly on the Money Illusion.  Choice quote:

Monetary policy should be boring, as it is in Australia; not exciting, as it is in the US and Japan.  Most of my readers think I am advocating use of monetary policy as a tool.  Most think I want it to be exciting.  Nothing could be further from the truth.