jamesz

TVHE is now international

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While Matt was busy lounging around in Colombia I packed my bags and moved to London. With agnitio in Auckland, that leaves Matt as the only remaining Wellington resident still blogging, although he makes up for that by writing 80% of the posts!

To celebrate my move to the UK it seems appropriate to reference football with this quote from the BoE governor, Mervyn King, in which he explains his ‘Maradona theory of interest rates’:

The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.

Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do. In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. They headed in a straight line for their goals. How was that possible? Because financial markets did not expect interest rates to remain constant. They expected that rates would move either up or down. Those expectations were sufficient – at times – to stabilise private spending while official interest rates in fact moved very little
…
That pattern is sometimes described as “the market doing the work for us”. I prefer a different description. It is the framework of monetary policy doing the work for us. Because inflation expectations matter to the behaviour of households and firms, the critical aspect of monetary policy is how the decisions of the central bank influence those expectations. As Michael Woodford has put it, “not only do expectations about policy matter, but, at least under current conditions, very little else matters”. Indeed, one can argue that the real influence of monetary policy is less the effect of any individual monthly decision on interest rates and more the ability of the framework of policy to condition inflation expectations. The precise “rule” which central banks follow is less important than their ability to condition expectations. That is a fundamental point on which my later argument will rest.

Matt Nolan

A book I have just preordered

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Via Economist’s View comes this excellent post by Economic Principals.

That the world economy received a “shock” when US government policy reversed itself in September 2008 and permitted Lehman Brothers to fail: what kind of an explanation is that?  Meanwhile, the shadow banking industry, a vast collection of financial intermediaries that included money market funds, investment banks, insurance companies and hedge funds, had grown to cycle and recycle (at some sort of rate of interest) the enormous sums of money that accrued as the world globalized. Finally, there was uncertainty, doubt, fear, and then panic. These institutions began running on each other.  No depositors standing on sidewalks – only traders staring dumbfounded at comport screens.

Only a theory beats another theory, of course. And the theory of financial crises has a long, long way to go before it is expressed in carefully-reasoned models and mapped into the rest of what we think we know about the behavior of the world economy.

This is all in preparation for a new book coming out – misunderstanding financial crises – which I have now preordered.

There appears to be a vein of distaste for DSGE models in this post, and this is the one bit I don’t agree with.  Economic methodology isn’t about having a “single model” – we try to be as reductionist as we can, but we have to instead rely on a suite of models that provide a narrative of different causal mechanisms that exist when people interact.  DSGE models are incredibly valuable, but they were never made to explain shocks – or to illustrate what happens when the shock is sufficiently large that we may not return to our previous equilibrium.

I’m also a bit confused about why the author appears to be hinting that modern economists don’t think that way – I clearly remember being taught about stability, multiple pareto ranked equilibrium, and the issue of bank runs.  I also remember being taught all this as part of “New Keynesian economics” and being told that DSGE models were in themselves only a subsection of the models we should look at when trying to understand what is going on around us.  And this was in 2005.

A more nuanced discussion of all this can be found here and here.  I am, as often, in agreement with Simon Wren-Lewis in this.  I fully agree with this statement:

However what seems to me critical in avoiding future crises is to understand why leverage increased (and was allowed to increase) in the first place, rather than the specifics of how it unravelled. As I suggested here, we may find more revealing answers by thinking about the political economy of how banks influenced regulations and regulators, rather than by thinking about the dynamics of networks.

While also accepting that the analysis of complex networks with multiple equilibrium is useful.  Why are economists so determined to create simple models rather than just making a full complex system that can be calibrated t fit data?  Easy – because these complex systems don’t tell us anything about causal mechanisms, and we need to understand causal mechanisms in order to determine what policies “make sense”.  It is a co-operative venture between multiple forms of modelling, not a competitive venture IMO.

Anyway, I’m looking forward to the book – and I’m currently reading the prequel, slapped by the invisible hand 😉

Matt Nolan

Dealing with debt, financial regulation, and the lender of last resort

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Previously we’ve talked a lot here about the lender of last resort function of a central bank.  In discussions a trade-off is often discussed, whereby having a lender of last resort can help to prevent financial crises when financial intermediaries are suffering from issues of “illiquidity”, but are not “insolvent” – however, the existence of a LOLR can in turn lead to moral hazard … where financial intermediaries and lenders are willing to take on “too much risk” and charger borrowers “too little”.

Although the discussion of these issues has a long history in economics, Thomas Sargent’s article (REPEC) on the issue – and the solution mentioned – are worth reading.

Now we live in a history dependent world.  Yes, we have had a global banking system willing to take on too much risk – due in a large part to issues of asymmetric information and an implicit solution subsidy of risk.  Yes, in this environment debt accumulated, and the existence of debt and the following credit constraints on people with “useful projects” that they could invest in is having a big negative impact – likely much bigger than any “social boost” that may have existed from the additional marginal projects that took place with easy credit.

We have an environment where people think there is a real risk of the failure of financial intermediaries.  Now if we understood “why” we could ask if there is a solution.  What are some reasons:

  1. There is too much debt.  If we saw this as an issue, we could convert bondholders into equity holders in banks.  After all, isn’t a government bailout really just a transfer from non-depositors to depositors in the bank?
  2. There is no trust.  There was a “capital stock” of trust that was built up between financial institutions, a stock that was destroyed and will have to be rebuilt.  This can be expected to keep hurting the efficiency of financial markets for a long time.
  3. Central banks/governments have lost credibility as lenders of last resort.  I think this is compelling – everyone talks about “too big to fail”, but exactly what that means, exactly what the “insurance” is, and exactly how the “insurance” is paid for are questions that are still up in the air. One can use Life Cover Quotes to find the best life insurance provider.
For me the key issue is the last one – as the negative impact of the first two is “endogenously determined” by the credibility of the financial system stemming from regulation.  The fact we have a government monopoly for fiat money, and direct management, combined with a LOLR function, ensures this.
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Note:  Anyone reading here since the crisis has been in full swing will think I lean strongly on the side of constant bailouts.  However, this is far from the case – I only started writing in favour of them once we already had a crisis where this needed to be the case.  In 2007, once the crisis had begun but a few months before Bear Sterns, I was writing like some sort of “purging our evils” Austrian economist.  After Lehman Brother’s collapse, even a half pint analyst like myself saw the issue of a lack of trust even when it was unclear whether there was a bailout or not 😛 (it was interesting reading these old posts, the lack of clarity around what was going on was even worse than I remember!).   By the time what happened was clear, we had switched our tune in favour of bailouts for that period of time – and even I found the ECB’s call to attack moral hazard in the middle of the crisis strange, even though I saw that as a big issue.

This was seen as a major issue coming into the crisis, it was viewed as a key issue during the crisis (I would argue that the efficiency of NGDP targeting would still depend on a banking system without bank runs), and now during these later stages of the crisis it is an issue receiving a lot of research and taken into account for regulation.  Mainstream economics has the tools to understand what has happened, and hopefully policies can be developed that ensure that the next economic crisis is something completely different.

Matt Nolan

New RBNZ PTA

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The new policy targets argreement is out today.  What have we got?

For the purpose of this agreement, the policy target shall be to keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium term, with a focus on keeping future average inflation near the 2 per cent target midpoint.

Oww I like this – actually stating the the implicit target IS 2%, not somewhere between 1-3%.  Improvement for sure.

In pursuing the objective of a stable general level of prices, the Bank shall monitor prices, including asset prices, as measured by a range of price indices. The price stability target will be defined in terms of the All Groups Consumers Price Index (CPI), as published by Statistics New Zealand.

I can understand including asset prices/credit growth in the PTA – its inclusion here seems a bit strange though.  Note that it is still only saying “look at how asset prices/other price indicies can forecast future growth in CPI”.  This change is on the face of it small, but maybe they see that the inclusion of asset prices itself could give them more scope to discuss it in statements.

In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner, have regard to the efficiency and soundness of the financial system, and seek to avoid unnecessary instability in output, interest rates and the exchange rate.

Explicitly mentioning the Banks implicit role as the lender of last resort and as responsible for the stability of the financial sector.  I always felt that we should have “two PTA’s”, and “two institutions” to split these roles – but having it explicitly mentioned is an improvement.  Now, in this context it is still seperate from monetary policy – so the financial stability reports and monetary policy statements will continue to focus on seperate things.

In the news release with the statement:

Mr Wheeler also emphasised that the macro-prudential policy tools currently being developed by the Bank should be separate from, but complementary to monetary policy. “The primary purpose of such tools will remain to promote stability of the financial system.”

Excellent – as it helps to improve the clarity of communication, which helps to guide expectations.

“In addition, the PTA’s stronger focus on financial stability makes it clearer that it may be appropriate to use monetary policy to lean against the build-up of financial imbalances, if the Reserve Bank believes this could prevent a sharper economic cycle in the future.”

I don’t really like this comment much – and I would say there is no consensus about whether such a comment is appropriate at present … namely the linkage between monetary policy in of itself (apart from other regulatory tools) and financial stability is highly debatable.

However, I gave my view of it to Alex from Rates Blog:

It is a sticky comment – but I would interpret it along with the fact that macro-prudential and monetary policy tools are complements.  As a result, the full impact of both monetary policy decisions and choices on macroprudential policies will be taken into account when ensuring that the financial system is sufficiently “stable”.

It is the comment I’m least happy about, as it is the issue that is likely to cause the most confusion, and where we have the least understanding – however, their determination to keep “communication” of the issues separate solves most of the problem I have with it.  After all, monetary, fiscal, and financial stability policies are all “complementary” in some sense – they all require co-ordination – and they should all focus on clear goals.

It’s one of those things where we won’t actually know whether there is any effective change until we see him in action – the December MPS will be interesting.  In of itself, this PTA is more “hawkish” than the previous one – both changes (2% target, focus on financial stability) imply tighter financial conditions over time IMO.

Update:  Bernard Hickey comments.

Matt Nolan

Debunking Keen on Bernanke: The issue of debt deflation

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From Twitter, and email adverts, I’ve heard the Steve Keen is or was in town discussing economics.  That’s good, everyone should be discussing economics.

As you may have noted earlier both Anti-Dismal and myself have had issues with Keen’s analysis in the past – his criticism of microeconomics is just patently wrong.  However, I intend to give him a fair go in his main field of macroeconomics – and will find media of him discussing his work in New Zealand to discuss.

Before I do this though, I have another area where I have to disagree with him strongly – his unfair slandering of Ben Bernanke in these two “essential posts” on his website.

I ran into these posts when I randomly ran into the article on debt deflation on Wikipedia (an article that also unfairly attacks Bernanke – compared to this one).  I was there because I had heard people going on about how we are experiencing debt deflation – something I found strange given that we aren’t experiencing deflation, or the scale of real declines in asset prices, which really are the key feature of a debt deflation episode.

Keen twice quotes the following passage from page 17 of The Macroeconomics of the Great Depression:  A comparative approach (REPEC).

Fisher’ s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects.

This makes it sound that Bernanke, and the economics discipline as a whole, doesn’t see wholesale declines in asset prices as any sort of significant issue.  Anyone following what central banks have been implementing over the past decade will know this is patently false, but it is worse than that.  He is also quoting Bernanke viciously out of context.

The article actually makes the case for how important this issue is – and then estimates the impact of this type of episode during the Great Depression and finds that it is very very important.  If we go down the page we find:

However, as the HMRC debt management has explained, the debt-deflation idea has recently experienced a revival, which has drawn its inspiration from the burgeoning literature on imperfect information and agency costs in capital markets …

From the agency perspective, a debt-deflation that unexpectedly redistributes wealth away from borrowers is not a macroeconomically neutral event: To the extent that potential borrowers have unique or lower-cost access to particular investment projects or spending opportunities, the loss of borrower net worth effectively cuts off these opportunities from the economy. Thus, for example, a financially distressed
firm may not be able to obtain working capital necessary to expand production, or to fund a project that would be viable under better financial conditions. Similarly, a household whose current nominal income has fallen relative to its debts may be barred from purchasing a new home, even though purchase is justified in a permanent-income sense. By inducing financial distress in borrower firms and households, debt-deflation can have real effects on the economy.

He also then goes on to discuss how it can hit financial stability by knocking out banks.  In the paper he discusses how debt deflation is a major issue, estimates a significant impact, and as an issue it is used to justify the lender of last resort function of a central bank – the very function that the ECB has refused to properly implement, helping to drive the current crisis.

Bernanke also places a link in a footnote to a paper he wrote, describing this very issue (NBR working paper here – and look at the major macroeconomists who helped edit it).

The only reason I can think of why Keen would so blatently misrepresent Bernanke is so that he comes off as smarter and more original than he actually is – that is a very harsh statement I nearly didn’t write, but I find what he’s done here verging on unforgivable … and as readers know, when someone does something like this I tend to get crabby.  If he is going to misquote and insult people, then I’m going to call it like it is. Update:  I’ve changed my mind – that comment by me was unnecessary, and inflamatory.  I should be saying why the misquoting is inappropriate instead of saying such things – my apologises.

Hell, the only reason I picked up on it so quickly was because I’ve recently reread these Bernanke essays when I purchased Essays on the Great Depression for my Kindle – if it wasn’t for that, I probably wouldn’t have even noticed.

But what about debt causing deflation!

This is the true claim to difference – mainstream economists do not say that debt causes deflation, however Keen believes this is the case and quotes Fisher as evidence.

Fisher wasn’t wrong – but he was discussing an economy under the gold standard … so it was an entirely different monetary regime that meant that in the face of this large non-monetary shock, the system created deflation.  Sure enough, we don’t have that sort of system now – and we haven’t seen the mass deflation that we did during the Great Depression.  The monetary regime now is a lot better, and outside of the ECB the lender of last resort function is widely accepted

Perhaps if he gave the writing of monetary policy experts like Bernanke a fairer reading, he may recognise this.

Matt Nolan

Interpretation and the model

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Following the Jackson Hole speeches there was this post over at Uneasy Money.  The money section for me is:

The reductions in long-term interest rates reflect not the success of QE, but its failure. Why was QE a failure? Because the only way in which QE could have provided an economic stimulus was by increasing total spending (nominal GDP) which would have meant rising prices that would have called forth an increase in output. The combination of rising prices and rising output would have caused expected real yields and expected inflation to rise, thereby driving nominal interest rates up, not down. The success of QE would have been measured by the extent to which it would have produced rising, not falling, interest rates.

Now this is an interesting quotation for me.  There is one thing I think I know – and that is that market interest rates are very hard to interpret, given the number of different things they are representing!

This quote argues with the simplified standard economic model that is put out there.  In that model, when there is an output gap central banks aim to get the realise real interest rate below its “natural level”, taking from this paper we have:

Thus, the mechanism through which monetary policy influences aggregate demand can be thought of as working as follows: Given the sluggish adjustment of prices, by varying the short-term nominal interest rate, the central bank is able to influence the short-term real interest rate and, hence, the corresponding real interest rate gap. Through its current and expected future policy settings, the central bank is able to affect the corresponding path of [the short term real interest rate gap] and, in turn, influence the long-term real rate gap … and the gap in Tobin’s q.

In this setting, monetary policy works by pushing down real interest rates (which happens by boosting inflation expectations and lowering the nominal interest rate) and by boosting aggregate asset prices.

But it is also true that if monetary policy “succeeds”, long term interest rates should be representative of the “natural” rate of real growth and inflation (as well as including factors for risk and time preference) … essentially the long term real interest rate is a constant.

From what I can tell, the afformentioned quote by Uneasy money relies on two things outside the basic model:

  1. A central bank sets expectations of nominal income growth, not inflation
  2. There are multiple equilibrium in the macroeconomy, making unemployment of the current sort the result of a failure in a co-ordination game.

However, if anyone has any more insight that can tie these view together, I would appreciate hearing it in the comments.