Winding and unwinding extraordinary monetary policy…

A must read speech for mon eco students. It is by David Miles of BoE.

He begins defending state of economics:

Before I get to that let me take one and a half minutes to say why I don’t feel inclined to devote time to apologising for the failings of economics. One reason is that the value of economics should not be gauged by how well economists can forecast the future. It is unfortunate then that many people are encouraged to think that this is pretty much the only yardstick to use. I think if you judged modern medicine by the same criterion you would not think it very valuable. But of course we don’t do that. We believe doctors are worth listening to if we have a broken leg or have a brain tumour even though they may not have been able to predict that you would be in that unfortunate position.

A second and stronger reason not to spend time apologising for economics is that one of the main criticisms made of it is so spectacularly wrong-headed that it should not be taken seriously. This is the criticism that economists became convinced that the actions of rational economic agents in shaping market outcomes would inevitably lead to stable and efficient outcomes.  According to this criticism, since we have plainly not had stable and efficient outcomes over the past 5 years, then it would seem to follow that the guiding principles of economics are deeply flawed. Those who think they are presenting a sophisticated version of this critique will specifically mention the rational expectations and efficient markets hypotheses. In fact all the efficient markets hypothesis really says is that financial outcomes are pretty much unpredictable – not that they are desirable or efficient in the everyday meaning of that term. And the rational expectations hypothesis is really a way of thinking that stresses the importance of people’s anticipation of future events in driving their decisions; it in no way means that the collective implications of such decisions must be optimal. 

He categorises list of all Econ Prize winners in memory of Alfred Nobel. Says most of them have been given for their work on how market outcomes could often be inefficient and sometimes unstable:

One indication of the dominance of this type of thinking – a type of thinking completely at odds with the caricature that economists claim that free market outcomes are stable and efficient – is the list of economists who have won Nobel prizes. The largest group of people on that list won their prizes for work which showed that market outcomes could often be inefficient and sometimes unstable1. See Annex 1. 

He then goes on to discuss several issues related to mon pol in the crisis. One major criticism is that despite all money being created via bank reserves, most reserves remain with the central bank. He says this does not tell us anything at all:

The money is going to come to sit at the Bank as reserves even if by its creation it has triggered multiple other transactions that have helped finance spending in the economy. This point is not well understood so let me take one minute to illustrate it.

Suppose the Bank of England buys an extra £1 million of gilts; the seller effectively gets a cheque drawn on the central bank. That cheque is cashed and so the bank of the seller of the gilt credits the seller’s account and the cheque is presented to the Bank of England who credits the account of the commercial bank. So bank deposits are higher as are reserves held by banks at the Bank of England. Suppose the seller of the gilt now buys a newly created corporate bond that will finance some new investment. The bank account of the company that issued that corporate bond goes up and that of the buyer of that bond goes down. Some money will flow between two commercial banks if the buyer and seller of the corporate bond have different banks – if that happens some reserves at the Bank of England will move from one bank to another.

The total level of reserves held at the Bank of England will not change. Now suppose in the next stage the company that issued the corporate bonds spends the money on investment, which means more wages and profits get generated somewhere else and so the money flows into bank accounts somewhere else. Economic activity is likely to be higher. Reserves may move (many times) from one bank’s account at the Bank of England to another. But aggregate reserves held at the Bank of England will not change at all. Just looking at what has happened to total reserves at the Bank of England tells you nothing about this. Nothing. If all that economics taught us is this it would have done some good.

 Well Sir, the problem has been not teaching economics properly at all. Much of this noise is created by top econs themselves and hardly cleared by them.

The best part is he talks about lots of basics of monetary economics – velocity of money, money multiplier etc…

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