Archive for June 4th, 2008

Central banks need to be countercyclical

June 4, 2008

I have pointed to a couple of articles on liquidity (see for instance What happened to liquidity? , What is liquidity? ). I read this speech from Mark Carney Governor of the Bank of Canada which is another good speech on liquidity. He also covers what happened to liquidity and what can be done about it.

However, I liked his comments towards the end where he discusses whether Central banks should have an asymmetrical appraoch to liquidity i.e just infuse liquidity:

Before closing, I would like to raise one final issue. Much of the discussion about central banks and liquidity in markets has been motivated by current circumstances, in which banks and market makers are unable to create a sufficient level of liquidity themselves. This is a one-sided approach to the issue. One of the reasons that the Bank of Canada’s monetary policy has been successful in anchoring inflation expectations is that we implement policy symmetrically…..

Is a symmetrical approach to liquidity also appropriate? As I mentioned earlier, a lack of liquidity can hamper the efficient allocation of resources and distribution of risk, and complicate the conduct of monetary policy. It is equally true that an overabundance of liquidity – or, more precisely, easy financing conditions for financial assets themselves – can have similar effects. Logically, if a central bank were concerned enough to lend to market makers in a time of scarce liquidity, would it not also want to borrow from the same institutions in periods of excess liquidity, again assuming that such periods could be determined with confidence?

Unfortunately, liquidity instruments such as those I have described today are poorly suited to this task. Central banks are the stores of liquidity in our economy, and can readily supply it by agreeing to take less-liquid assets from counterparties in exchange. Generally speaking, central banks are not set up to operate in reverse; that is, they do not have on their balance sheets a ready supply of illiquid assets that can be used to absorb excess liquidity held by banks or market makers. Moreover, during an asset boom, they may have limited influence over the confidence of financial market participants.

The principle, however, remains. Central banks and other authorities should be as concerned about the distortions and inefficiencies created by overly easy financing conditions, rapid credit growth, and excess confidence about future market liquidity as those created by a lack of liquidity. So how can we achieve symmetry in our approach? In my opinion, it is worthwhile for policy-makers to consider the promotion of macro-prudential regulations that could serve to restrain pro-cyclical liquidity creation among banks and market makers when appropriate. To be clear, the same tests should apply in terms of “when appropriate.” There would also be the added complication of determining where to house this regulatory authority, and how it would be coordinated across jurisdictions. Despite these issues, this is a serious concern that warrants closer attention.

Now, if you note Bank of Canada is an inflation targeting (IT) Central bank but is worried about high growth in credit, asset prices etc. As I have noted previously as well, IT Central banks seem to be more worried about financial markets and growth and not about inflation really. Infact, reading the various statements one actually feels when it comes between falling growth and high inflation, Central Banks tend to focus on former.


Marcus Brunnermeier explains sub-prime crisis

June 4, 2008

There was recently a superb story in WSJ about Bernanke’s Bubbles Lab. On reading the article I came across work of Prof Marcus Brunnermeier (of  Princeton University) and decided to take a look at it.

Prof Brunnermeier is an expert in financial bubbles (which is of course) and much of his research centres on how bubbles take shape and what can we do about it. He has provided a very neat summary of his work.

His researchon sub-prime crisis is a must read for all those interested in the development. Unlike previous research by Rogoff et al and Michael Bordo (covered here) which says no crisis is different and looks at broad economic indicators of crisis, Prof Brunnermeier instead looks at various financial variables to explain the crisis-  liquidity, financial indices and moreover how financial firms actually work.

Highly recommended!

PS. Infact all his papers are worth a read.

Assorted Links

June 4, 2008

1. IE Blog has two superb posts on price of crude oil- On The Price of Crude Oil, Upsetting Oil Pricing Conundrum

2. Finance Clipping points to technical charts showing appearance of a Black Swan!!

3. WSJ blog points Fed welcoming weak dollar

4. Nudges points to importance of optimism. It also points to beh eco lesons for healthcare

5. PIB points that only one person should pay for shared meals

6. Rodrik points to Martin Wolf’s take on Growth Commission. PSD Blog also has some comments

7. IC Law Blog points to lessons from Bear Stearns

8. Ajay Shah responds to Vivek Moorthy

9. IS BLog explains NHDP

10. EPSA Blog on governance

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